What is Downside Risk?

Downside risk is the amount of loss that will be sustained in a worst-case scenario. This analysis may be conducted just for an investment in securities, or in regard to any fixed asset project. The extent of the risk depends on the type of investment. For example, an investment in an asset has a maximum downside risk of losing the entire amount of the investment. Conversely, investing in a short sale can result in a potentially unlimited downside loss.

Investors are more likely to accept a significant downside risk when there is an offsetting and quite large amount of upside gain. The amount of downside risk that an investor is willing to accept will depend on the person's investment objectives and tolerance for risk.

The Limits of Downside Risk

Some investments are capped at the amount of downside risk that they can sustain. For example, an investment in stock is limited to the amount paid for the stock, so that you can only lose the amount that you paid. However, some downside risks are much greater. For example, engaging in short selling can subject you to potentially unlimited downside risk. Or, if you purchased a property that turned out to have massive hazardous waste obligations, the cost to remediate these conditions could far exceed the purchase price of the property.