While classic indicators like as standard deviation and Sharpe ratio are necessary in explaining volatility and efficiency, they cannot statistically capture the entire picture of risk, especially during market downturns. In this blog, we'll look at five key measures for assessing downside risk: downside capture ratio, down market beta, down market correlation, worst-case CAGR, and maximum drawdown.
Downside Capture Ratio:
The downside capture ratio measures how a portfolio performs relative to a benchmark during periods of market decline. For example, if the market index experiences a 10% decline, and the portfolio only drops by 8%, the downside capture ratio would be 80%. A lower downside capture ratio indicates better downside protection.
Down Market Beta:
Unlike traditional beta, which measures overall market volatility, down market beta focuses specifically on market downturns. It quantifies how much a portfolio's returns deviate from the benchmark during bear markets, providing insights into downside risk management.
Down Market Correlation:
Down market correlation evaluates the degree to which a portfolio's returns move in tandem with the market during downturns. A correlation close to -1 indicates that the portfolio tends to perform inversely to the market during downturns, offering valuable diversification benefits.
Worst-Case CAGR:
While Compound Annual Growth Rate (CAGR) provides a long-term perspective on portfolio performance, worst-case CAGR focuses on the lowest achievable growth rate over a specified period. It offers a conservative estimate of long-term returns, considering the impact of severe market downturns.
Maximum Drawdown:
Maximum drawdown represents the largest peak-to-trough decline in portfolio value over a specific period, reflecting the extent of loss experienced during adverse market conditions. Although max drawdown may not capture the frequency or duration of drawdowns and is the least repeatable of the aforementioned indicators, it still serves as a relevant measure of downside risk tolerance.
Real-Life Examples:
Consider two portfolios, Portfolio A and Portfolio B, during a market downturn. Portfolio A exhibits a higher downside capture ratio, down market beta, and down market correlation compared to Portfolio B. Consequently, Portfolio B experiences smaller losses relative to the benchmark, showcasing superior downside protection.
Furthermore, while both portfolios may have similar average returns (CAGR), Portfolio B's worst-case CAGR and maximum drawdown are significantly lower than Portfolio A's, highlighting its resilience during adverse market conditions.
Conclusion:
By using these metrics, advisors can better grasp downside risk and create portfolios to better handle market shifts. While historical data and standard metrics are helpful, considering these factors is vital for creating strong portfolios. These metrics also help clients grasp the reality of investing, showing that occasional dips are part of the long-term investment journey.