Q1. If downside risk is so much better than other risk measures, why isn't everybody using it?

A. Thomas Kuhn was a philosophy professor at M.I.T. University. His book, "The Structure of Scientific Revolutions," offers some interesting insights into the nature of paradigm shifts in the scientific community. He notes that the scientific community has never been persuaded by facts to shift from one paradigm to another. The views of Copernicus were not generally accepted for a century after his death. A half century after the publication of Principia by Newton, the facts he presented were not generally accepted. Max Plank remarked, "a new truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die."

If this is the case in the hard sciences, imagine how much more difficult it is to get new paradigms accepted in a soft science like financial economics. When I started in the investment business in 1960, there was no attempt to quantify risk. It took twenty years before the work of Markowitz was taught throughout the academic community and another decade before put into practice by many consulting firms. For the past fifteen years I have tried to show that downside risk is an extension of the risk/return framework presented by Markowitz.

This begs the question, why is there such opposition to the application of downside risk in performance measurement and asset allocation?  There are two issues here. One is the time and expense of building software that incorporates downside risk, and the second is the problem of educating people in its use. I recall the president of a large consulting firm telling me, "we are not in the education business. We give clients what they want. When they start demanding downside risk, I'll call you." The second is the simpleton factor. A wall street pundit recently remarked that consultants should not bother clients with difficult to understand risk measures, "just tell them how badly the fund did in its three worst months." Well, that certainly simplifies the task of gathering data to 3 observations.  For a more scientific approach see the section on the bootstrap procedure under "current research, click on Two Stage Asset Allocation."

Forbes Sheds Light!

Since the article "Focus On The Downside" appeared in Forbes magazine February 10, 1999, we have had a number of requests for information on how to calculate downside risk.  In an effort to advance the knowledge of risk measurement, we have decidid to offer free software to calculate downside risk and the Sortino Ratio.  To download this software click  Free Software.

Q2. What good is downside risk if I don't know what my MAR is, or I get it wrong?

A. Do you know what your goal is? If you know what you are trying to accomplish, there is some return that must be earned at minimum in order to accomplish your goal.  It would behoove you to know what that is. If you don't know, chances are you will end up pursuing someone else's goal. To parody "Alice in Wonderland" if you don't know where you're going, it doesn't matter what your MAR is.  It is my experience that most investors, institutional and individual, confuse their goals with the goal of the portfolio manager they hire.

As for accuracy, it is true that one can never know with certainty what the MAR is. But, that is like saying, one can never know what compass heading to steer in order to fly from San Francisco to Hawaii. There are lines of magnetic deviation from the north pole that throw compasses off, and even if you steer a magnetic heading, the winds aloft are sure to be different than when estimated before take-off. That's why pilots check their position often to make the necessary corrections to get to their destination. Performance measurement should provide that position check for investors. Without a proper flight plan for your destination, you may find yourself on the world's fastest plane to someone else's destination. Estimating the MAR is a lot easier than estimating expected returns on stocks and bonds. So, why aren't more people doing it? (see the answer to the first question).

The goal is not to make money.   Making money is how you accomplish your goal.  If your consultant or financial planner didn't find out what your goal is, and didn't tell you what MAR is needed to accomplish your goal…that ought to tell you something.

Q3. Why not just use the three worst months or the worst year as an indicator of downside risk?

A. This was touched on in the first answer.  Statistics provides us with tools for extrapolating from past events, what could happen in the future.  Bradley Effron at Stanford University has developed a statistical methodology called the bootstrap procedure that provides a picture of what could have happened in the past, based on what did happen.  It requires at least three years of monthly returns to provide reasonable estimates.  Remember that the Japanese stock market went up every year for ten years, until 1990, when it plunged almost 40%.  The bootstrap procedure showed that this could happen.  Looking at the worst three months or the worst year did not.  For details on how this procedure works, click on Work in Progress at the bottom of this screen and then click on "Managing Uncertainty".  A detailed explanation of the bootstrap procedure is provided there.   

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