Ever heard of Semi-standard deviation and its relevance in investment management?

Semi-standard Deviation allows potential investors to understand how much downside volatility the ETF has experienced, versus standard deviation, which examines all volatility-upside + downside. It’s widely accepted that investors are more concerned about volatility on the downside in analyzing risk. – Morningstar

Just to give you a taste behind the concept of semi-standard deviation while managing investments, imagine this situation:

You are considering 2 assets for investment, both of while have same mean and standard deviation. (You may think that since both have same standard deviation, so they will be having same risk associated with them, let me tell you that you are not fully wrong though not fully rational as well!) 🙂

By being rational, I mean to have more preference for positive returns than negative returns. Now imagine, the distribution of the returns of asset A show some distant points in positive region making the tail in positive region fatter and showing a positive skew.

Asset B is normally distributed.

Now, when you know these characteristics what you need to see is the downside risk.

As per the definition of risk – It reflects uncertainty, it doesn’t distinguish between good or bad, positive or negative. Risk is everything which doesn’t fall in a range.

But, as an investor if an asset is supposed to give returns @ 7% and you get 3% (can be called as risk) or even a return of 15% from that asset will also be labelled as risk. But, that’s from theory point of view. Will you practically mind 15%? No, Right?

So, to come up with this dilemma, fund managers are evaluated with Sortino Ratio to measure their fund’s performance (Here the negative deviations/shortfall from the mean are only taken into account for risk and the positive deviations are not taken to calculated the risk associated with the fund/asset).

Semideviation [Source: Investopedia.com]

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