What is downside risk?
This refers to the financial risk attached to a particular security in the event that it loses value. This can illustrate a worst-case scenario for an investor, which may be finite or infinite, depending on the instrument in question.
Where have you heard about downside risk?
Initially modelled by Roy in 1952, theories on downside risk are frequently used by analysts today to predict potential losses from future investments. The level of downside risk will often play a role in determining whether a potential investor buys a certain security.
What you need to know about downside risk...
It is important to understand that some investments have a finite downside risk, while others carry a risk of infinite losses. An example of the former is when a trader buys a stock - it is only possible to lose the entire value of this investment. An example of infinite risk is when an investor holds a short position on a security after a short sale, as its price could theoretically continue to rise forever. Investments that offer larger levels of downside risk may often offer higher levels of potential profit, although losses are possible.