Downside risk has to do with the potential for an investment to decrease in value once it has been acquired. Since the idea behind investing is to generate some sort of return above and beyond the original purchase price, investors will utilize several different tools to determine the potential of an investment before making that purchase. Factors such as past performance, current market share, and growth potential are all important to the tasks of accurately assessing the degree of downside risk associated with any given investment opportunity.
When considering an investment opportunity that involves stock options, an investor will look closely at the history of that stock’s performance. Doing so makes it possible to understand how the stock price increased or decreased when particular market conditions took place. Assuming there are periods of stock price decline over the last five years, the investor can take into consideration what factors led to that decline, determine if they are likely to occur again within a given period of time, and base the decision to buy on that data.
For example, if the last time that the stock experienced a downturn was when a highly respected executive left the company, and there are no indications that a similar issue will arise over the next two to three years, the investor may consider the level of downside risk to be acceptable. This is especially true of the projected return is considered equitable, as demonstrated by the dividend yield generated in the recent past. Should projections of market movement indicate that the market will be stable during those years, this is likely to further reduce the downside risk that the investor assumes, and thus make the stock more attractive.
Shifts in the marketplace are also important to the task of assessing the degree of downside risk associated with any investment opportunity. This shift may be in the form of anticipated changes in demand for the products produced by the company issuing the stock option. Should there be indications that new technology will render the products obsolete over the next few years, the downside risk may be somewhat high, even if the options have performed well in the past, and are currently performing well. In this scenario, the investor may choose to purchase shares and hold them for a short period of time, then sell them before the new technology begins to erode the demand for the company’s products.
