Downside risk we know—and we know it’s something to be mitigated, avoided, offset, and, worst-case, accepted. Generally, we consider downside risk something to stay as far away from as possible while remaining in the investment arena. But upside risk? You mean the chance that an investment will increase in value beyond my reasonable expectations? Oh, yeah. I can handle as much of that as I can get, is your first instinct.
Actually, modern portfolio theory measures risk in terms of standard deviation of returns. There’s a base line, and both positive returns (above that line) and negative returns (below that line) are considered to be risks in that the results deviated from what was expected based on decades of history. According to portfolio theorists, risk is just variance by another name.
Fundamental analysis and technical analysis are two basic ways of analyzing past market behavior and making investment predictions for future strategizing. Each of these methods can be used to understand downside and upside risk. Fundamental analysis looks at the state of different industries and of the economy overall, as well as how efficiently a particular company is being run. Technical analysts, by contrast, focus on price movements and trading volume. In either case, there is a benchmark or baseline to which data is compared in judging future risk.
In general, as an individual investor, it’s a good idea to focus on both upside and downside risk. True, if you take on too much risk, focusing exclusively on gains, it can take a long time to break even after a large loss. On the other hand, if you focus exclusively on preserving your capital, chances are you’ll miss out on substantial market gains on the upside.
Upside beta, used to measure upside risk, uses data only from days when an investment’s benchmark has gone up, and sometimes, an upside risk statistic can serve as a signal that a particular investment manager is taking excessive risks. But whether or not the data lead to that conclusion, comparing the upside and downside risks for a particular stock or bond allows you to assess both potential losses and potential gains. In the course of pursuing positive objectives, we introduce or increase the potential for adverse events, observes Jack Jones of the FAIR Institute.
The term Beta simply describes the baseline to which past investment results are compared, on both the upside and the downside. It’s a reminder that, when we’re making investment choices based on a judgment of what has been “better,” we need to ask “better than what?” To be sure, both upside risk and downside risk are, at best, only partially predictable. Solid decision-making allows for rosy possibilities along with gloomy prospects, looking at things on the upside along with the downside. Sheaff Brock helps both individual and institutional investors make sense of investing.