Downside Deviation

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Downside Deviation (or DD) is measured by target semi-deviation (the square root of target semi-variance) and is termed downside risk. It is expressed in percentages and therefore allows for rankings in the same way as standard deviation. An intuitive way to view downside risk is the annualized standard deviation of returns below the target.

Downside Deviation 
=  
SQRT(DV) 

It is the square root of the probability-weighted squared below-target returns. The squaring of the below-target returns has the effect of penalizing failures at an exponential rate. This is consistent with observations made on the behavior of most private investors.

Downside Deviation In A Nutshell

If you have not done so or need a refresher, it may benefit you to familiarize yourself with standard deviation, as that can work both to the upside and to the downside. However, downside deviation will only focus on the downside and with using standard deviation, it is focusing on both the upside and downside equally.

Starting with a simple definition, downside deviation measures downside risk. Beyond that, there is more that can help you to become more informed of your current investments or potential investments. This type of deviation will also work with your minimum return you are expecting.

Closer Look at Downside Deviation

So now that we know downside deviation only focuses on the downside, here are a few benefits to using it in your research. First, the fact that it does only focus on the downside is great because it will give you data that is only representative of the downside. Now, with that comes the assumption that there is enough negative data to give you a well calculated number. Secondly, this can help you find where you put in your stop losses and decide when you might get out of a position. Lastly, it is taking data that has already occurred, giving you an accurate representation of the past performances, limited to the downside.

Some of the disadvantages are that first, it does only focus on the downside risk. You want to ensure you have a good take profit level set as well, and that may be aided with standard deviation. Secondly, if there is not enough negative data, you may not get an accurate data point for the downside. Lastly, it does not take into account the current market conditions and fundamentals that can propel a stock lower. So it should be mentioned to not rely on this on its own.

Using deviations are great because they can give you accurate areas of where the market may turn and slow. Even better, downside deviation can take into account only the negatives, and give you levels to watch incase your equity falls. Be sure to test it in your current trading and investing situation because you may find that it does not complement your current situation. Always feel free to reach out to an investing community as this can be the best source of information, as people give you real time feedback that can give you an edge in your current investing and trading.