Chapter 8 - Investment risk: A unified approach to upside and downside returns

Abstract

This chapter provides an understanding of the essential nature of investment risk and of the strengths and weaknesses of various risk measures. In addition, the chapter reviews the commonly used or proposed risk measures, points out their strengths and weaknesses, and develops a unified theory of the utility of upside and downside returns relative to the investor's benchmark(s). The unified theory provides a coherent, powerful, and elegant framework for real investment decisions in portfolio management. Realistic measure of investment risk is asymmetric, relative to one or more variable benchmark(s), investor-specific, and multidimensional. Investment risk is vast; it is due to the increasing use of financial instruments with asymmetric pay-offs and to non-linear trading or portfolio management strategies. Such assets and strategies encourage and produce essentially asymmetric investment return distributions, which in turn highlight the intrinsic shortcomings of using variance or standard deviation as the only measure of investment risk. Investors and their advisers further reinforce the trend by selecting and rewarding not only managers who produce high returns, but also those who produce asymmetric distributions of value-added above benchmark with enhanced upside and curtailed downside.