Downside Risk

Written By
Paul Tracy
Updated November 4, 2020

What is a Downside Risk?

Downside risk is the probability that an asset will fall in price. It is also the measure of the possible loss from that decline.

How Does a Downside Risk Work?

Let's assume an investor owns 1,000 shares of Company XYZ and she's paid $100,000 to own that stock. Because the stock price could theoretically fall to zero under the right economic conditions, the downside risk of the investment is 100% or $100,000.

Hedging is an attempt to limit the downside risk of an investment. In our example, the investor might purchase a put option on the shares, meaning that she has the right to force the counterparty to buy the Company XYZ shares for a certain price. That way, the investor can obtain at least a minimum amount for the shares and thus limit her downside risk.

[InvestingAnswers Feature: How to Use Protective Puts to Limit Losses]

Why Does a Downside Risk Matter?

Evaluating downside risk helps investors avoid focusing solely on performance statistics. It also helps them plan for the worst and navigate difficult markets with less emotion or fear. Several financial studies show that the higher a stock's downside risk is, the more it should be expected to return.

Some studies have also found that stocks with high past returns have more downside risk than stocks with low past returns. That is, they're more likely to tank when the market falters.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Downside Risk.
Be the first to ask a question

If you have a question about Downside Risk, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Downside Risk, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Downside Risk

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms