What Is Downside Deviation?
Downside deviation is a proportion of downside risk that focuses on returns that fall below a minimum threshold or minimum acceptable give (MAR). It is used in the calculation of the Sortino ratio, a measure of risk-adjusted return. The Sortino ratio is like the Sharpe ratio, except that it supplants the standard deviation with downside deviation.
Key Takeaways
- Downside deviation is a measure of downside risk that focuses on redresses that fall below a minimum threshold or minimum acceptable return (MAR).
- Downside deviation gives you a better philosophy of how much an investment can lose than standard deviation alone.
- Downside deviation does not convey any information thither upside potential, so it provides an incomplete picture.
Understanding Downside Deviation
Standard deviation, the most widely tempered to measure of investment risk, has some limitations. For example, it treats all deviations from the average—whether positive or unenthusiastic—as the same. However, investors are generally only bothered by negative surprises. Downside deviation resolves this broadcasting by focusing solely on downside risk. However, downside deviation is not the only way to look at losses. Maximum drawdown (MDD) is another way of regulating downside risk.
An additional advantage of downside deviation over standard deviation is that downside deviation can also be tailored to the delineated objectives. It can change to fit the risk profiles of different investors with various levels of minimum acceptable return.
The Sortino and Sharpe correspondences enable investors to compare investments with different levels of volatility, or in the case of the Sortino ratio, downside peril. Both ratios look at excess return, the amount of return above the risk-free rate. Short-term Treasury sanctuaries often represent the risk-free rate. Suppose two investments have the same expected return, say 10%. However, one has a downside deviation of 9%, and the other has a downside deviation of 5%. Which one is the heartier investment? The Sortino ratio says that the second one is better, and it quantifies the difference.
Calculation of Downside Deviation
The commencement step of calculating the downside deviation is to choose a minimum acceptable return (MAR). Popular choices include zero and the
Downside Deviation Input Observations Year Return Return – MAR (1) 2011 -2% -3% 2012 16% 15% 2013 31% 30% 2014 17% 16% 2015 -11% -12% 2016 21% 20% 2017 26% 25% 2018 -3% -4% 2019 38% 37%The third step is to separate all of the negative numbers, in this case, -3, -12, and -4. Then, we quadrilateral the negative numbers to obtain 9, 144, and 16. The next step is to sum the squares, which gives us 169 in this victim. After that, we divide it by the number of observations, 9 in our example, to get about 18.78. Finally, we take the square rootlet of that number to get the downside deviation, which is about 4.33% in this case.
What Downside Deviation Can Discern You
Downside deviation gives you a better idea of how much an investment can lose than standard deviation alone. Pier deviation measures
Limitations of Downside Deviation
Downside deviation does not convey any information about upside what it takes, so it provides an incomplete picture. In the previous example, we learned that an investment with a 50% chance of getting 40% and a 50% unplanned of getting 20% had the same downside deviation as getting 5% for sure if we use 5% as the minimum acceptable return (MAR). In all events, the first investment has much higher upside potential. In fact, it is guaranteed to outperform, the only question is by how much.