Upside risk

In investing, upside risk is the uncertain possibility of gain. It is measured by upside beta. An alternative measure of upside risk is the upper semi-deviation. Upside risk is calculated using data only from days when the benchmark (for example S&P 500 Index) has gone up.[1] Upside risk focuses on uncertain positive returns rather than negative returns. For this reason, upside risk is not a “risk” at all in the sense of a possibility of adverse outcomes. It is actually beneficial to investors, because it represents the element of beta that investors profit from. Therefore, higher upside risk is better than lower, and upside risk is preferable to downside risk.

Upside risk vs. Capital Asset Pricing Model

Looking at upside risk and downside risk separately provides much more useful information to investors than does only looking at the single Capital Asset Pricing Model (CAPM) beta. The comparison of upside to downside risk is necessary because “modern portfolio theory measures risk in terms of standard deviation of asset returns, which treats both positive and negative deviations from expected returns as risk.”[1] In other words, regular beta measures both upside and downside risk, the former being beneficial to investors and the latter being the risk that investors should minimize. This is a major distinction that the CAPM fails to take into account, because the model assumes that upside beta and downside beta are the same. In reality, they are seldom the same, and making the distinction between upside and downside risk is necessary and important.[2]

Examples

“One can have a situation where an asset with tremendous upside movement and little downside movement would appear to be riskier than another asset with moderate upside or downside movement.”[3] In other words, a stock with a high upside beta might generate the illusion of risk. For example, one can consider stocks A and B, which have the same downside risk. However, stock A’s upside beta is larger than the upside beta of stock B. Stock A’s CAPM beta will be larger than that of stock B, and thus stock A might be viewed by some investors as being more risky. In reality, stocks A and B have the same level of risk because they both have same downside risks, and stock A would actually be a more profitable stock to invest in. An investor who looked at the upside and downside risks of these two stocks separately would see this distinction, and be able to make the more logical investing decision, whereas an investor who relied only upon the CAPM beta would not.

See also

References

  1. 1 2 James Chong, Ph.D.; Yanbo Jin, Ph.D.; G. Michael Phillips, Ph.D. (April 29, 2013). "The Entrepreneur's Cost of Capital: Incorporating Downside Risk in the Buildup Method" (PDF). p. 3. Retrieved 26 June 2013. Cite uses deprecated parameter |coauthors= (help)
  2. ↑ Chong, James, Ph.D.; Pfeiffer, Shaun, Ph.D.; Phillips, Michael G., Ph.D. (2011). "Can Dual Beta Filtering Improve Investor Performance" (PDF). Journal of Personal Finance. 10 (1): 9. Retrieved 26 June 2013. Cite uses deprecated parameter |coauthors= (help)
  3. ↑ Chong, J.; Phillips, G.M. (2011). "Beta Measures Market Risk Except When It Doesn't: Regime Switching Alpha and Errors in Beta". Journal of Wealth Management. 14: 67–72.

External links

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