Downside Risk

Downside risk includes both the likelihood and extent to which a stock's price may decline. Analysts use various measures to assess the downside risk of a stock. For example, stocks that are selling at the low end of their historical price-earnings ratio would appear to have relatively limited downside risk, because investors will perceive the stock as offering good long-term value. Also, stocks whose dividend yield is both high and safe would also have seemingly little downside risk, because investors should continue to buy the stock at that price for the cash return. On the other hand, stocks with historically high P/Es may have relatively high downside risk, because they may appear overvalued. For conservative investors, limited downside risk may be key. But for investors who seek to maximize their returns, limited downside risk is just one factor to be considered in buying an equity. While limited downside risk is a positive, it comes at a price: Not surprisingly, it is often those stocks that have the least downside risk that also have the least potential for price appreciation.