A downside-risk approach to investment decisions uses intuitive measures of risk that focus on return dispersions below a specified target or benchmark return. Downside-risk measures are attractive not only because they are consistent with investors’ perception of risk, but also because the theoretical assumptions required to justify their use are very simple. Equally important, a number of well known risk measures, including the traditional variance (standard deviation) measure, are special cases of the downside-risk approach. Asset allocation in a downside-risk framework therefore determines an investment opportunity set for downside-averse investors that is at least as efficient as that derived using conventional techniques.
A set of international asset allocation examples demonstrates the benefits of the downside-risk framework. Specifically, optimizations based on downside measures produce portfolio strategies with realized returns that have less downside risk exposure than those determined using variance. Thus investors averse to below-target return dispersions achieve a more attractive risk-return tradeoff within this framework. Moreover, in the asset allocation examples considered, the downside-risk approach produces a significantly higher average bond allocation relative to stocks. This difference in asset composition increases downside protection while offering the same or a greater level of expected return.
