What Is a Downside?
A downside is a negative movement in the price of a security, sector or market. A downside can also refer to economic conditions, describing potential periods when an economy has either stopped growing or is shrinking. When used colloquially, downsides can also refer to tradeoffs or negative consequences of an otherwise beneficial decision.
In finance, downside risk is an important consideration when choosing an investment. Some investments have potentially infinite downsides, meaning that there is no limit to their potential losses.
Key Takeaways
- A downside describes the negative movement of an economy, or the price of a security, sector, or market.
- Professional investors limit their downside by hedging their positions.
- The theoretical downside for a buyer of a stock is 100% if that stock falls to $0.
- The downside for someone shorting a stock is not capped and is theoretically infinite.
- In most investments, the higher the downside potential the greater the upside potential.
Understanding Downside
Downsides are expressed in terms of an estimation of a security or economy's potential to experience negative movement. A stock analyst, for example, may forecast how far a stock price might fall because of certain events. Meanwhile, economists can predict the downside to a country's economy by taking into consideration factors such as the unemployment rate, inflation, and gross domestic product (GDP) growth.
Examples of Downside
Let's say an investor paid $100,000 to own 1,000 shares in Company ABC. Though unlikely, the stock price could potentially fall to $0, meaning the downside risk of the investment is 100% or $100,000. That’s where calculating downside risk comes into play. In general, the higher the risk the greater the downside risk.
For most assets the downside is capped, as a price cannot go below $0. Exceptions include short selling, a trading strategy that enables investors to speculate on the decline of a stock or other securities price. If the price of an assetyou shorted rises, you lose money. Moreover, your downside is theoretically infinite, as the price can keep on climbing.
Unlike buying stocks, a short trade has potentially unlimited downside.
Downside Protection Strategies
Investors can protect their portfolios against adownside by hedging their losses. This is known as downside protection. Downside protectionprovides a safety net if an investment starts to fall in value. This can be achieved in several ways, including:
Put Options
A put option is a contract giving the owner the right, but not the obligation, to sell a specified amount of anunderlying securityat a specified price within a certain timeframe. If the price of the stock falls, the investor can either sell the stock at the price listed on the put or sell the put since it will have increased in value because it isin the money.
Stop Loss Orders
When trading securities on an exchange, a stop loss is an order placed with a broker to automatically sell a security when it falls at or below a certain price.
Diversification
A diversified portfolio made up of assets that are negatively correlated can ease downside risk. When one rises, the other tends to fall, cushioning losses but also limiting potential gains.
Alternatively, investors might opt to wait out a market correction, hoping that the stock will bounce back in the future.
Money on the Sidelines
Money on the sidelines refers to cash that has not been invested or is kept in highly liquid assets like money market funds or certificates of deposit. Sidelines are used by investors hoping to "wait out" market downturns, by removing their money from the most volatile instruments and keeping it liquid enough that they can easily reinvest in promising opportunities.
One of the most important lessons of investing is diversification. Don't put all your eggs in the same basket!
Downside vs. Downside Risk
A movement to the downside is often expressed in terms of risk, such as the downside risk to a particular country's economy, or the downside risk to a company’s stock because of changing consumer trends.A downside is the potential negative movement, while downside risk looks to quantify that potential move.
For the most part, the higher the downside potential the greater the upside potential. This goes backto the idea of the higher the risk, the higher the reward. An upside is a positive move in an asset price.
Downside risk can be evaluated with fundamental and technical factors, estimating the amount a security or asset price might fall in the worst-case scenario. This can be done using probabilities or standard deviation models, although there is no way to perfectly estimate the downside unless some sort of downside protection is in place.
Upside/Downside Ratio
In technical analysis, the upside/downside ratio is used to determine whether a market is overbought or oversold. It is calculated by dividing the number of advancing issues (the number of securities that closed above their opening price) by the number of declining issues (the securities that closed below their opening price). This is another variation of the advance/decline ratio.
If the upside/downside ratio is lower than one, the market for that security is likely to be oversold, meaning that there are very few sellers left to sell at the current price. In this case, the price might be expected to begin rising. The reverse is true if the ratio is higher than one, indicating overbought conditions.
What Is the Downside of Filing for Bankruptcy?
Filing for bankruptcy is an expensive and complicated process that should only be attempted as a last resort. In addition to the cost of legal filings, a bankruptcy will remain on your credit report for seven to ten years, making it difficult to borrow money or rent a home in the future. You may also lose control of any real estate or other property, which will be liquidated in order to repay your creditors.
What Is the Downside to a Reverse Mortgage?
A reverse mortgage is a loan that uses the borrower's home as collateral and becomes due when the borrower dies. Although popular among retired homeowners, this type of loan can have serious drawbacks for the borrower or their estate. First, borrowers will spend a significant amount of their equity on loan fees and interest, and they will be unable to pass the home down to their heirs. Depending on the mortgage, there is also a chance that the borrower may outlive the mortgage proceeds and run out of money.
What Are the Downsides of Rapid Economic Growth?
While economic growth is generally considered beneficial, it tends to be accompanied by drawbacks, especially for the most vulnerable parts of the population. For example, while industrialization was able to increase gross economic output, it also resulted in environmental and health consequences, as well as poverty and overcrowding in the largest cities. Similarly, globalization tends to improve net economic productivity, but it may impoverish indigenous peoples who rely on traditional forms of economic activity.
