Understanding Downside Deviation: Definition, Uses, and Calculation

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Updated October 02, 2025
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What Is Downside Deviation?

Downside deviation measures downside risk by focusing on returns below a minimum acceptable return (MAR). It helps calculate the Sortino ratio, which gauges risk-adjusted return. The Sortino ratio is like the Sharpe ratio, except that it replaces the standard deviation with downside deviation, placing the focus only on the downside risk. Downside deviation is a risk assessment tool that emphasizes losses rather than returns and is adaptable to individual risk profiles and investment objectives.

Key Takeaways

  • Downside deviation measures risk by focusing on returns below a minimum threshold, unlike standard deviation, which considers all deviations.
  • It helps investors understand potential losses in an investment, offering a clearer risk picture than standard deviation alone.
  • Downside deviation can be customized according to specific investor risk profiles by setting different minimum acceptable returns.
  • While it highlights downside risk, downside deviation does not provide information about potential gains, offering an incomplete investment evaluation.
  • The Sortino ratio uses downside deviation to compare investments with varying volatility, focusing on risk-adjusted returns.

How Downside Deviation Differs from Standard Deviation

Standard deviation, a common measure of investment risk, has drawbacks. It treats all deviations from the average equally, but investors usually focus on negative outcomes. However, investors are generally only bothered by negative surprises. Downside deviation resolves this issue by focusing solely on downside risk. However, downside deviation is not the only way to look at losses. Maximum drawdown (MDD) is another way of measuring downside risk.

An advantage of downside deviation is its ability to be customized. It can adapt to the risk profiles of different investors with varying minimum return levels. The Sortino and Sharpe ratios help investors compare investments with different volatility or downside risk. Both consider excess return over the risk-free rate.

Suppose two investments have the same expected return, say 10%. However, one has a downside deviation of 9%, and the other has a downside deviation of 5%. Which one is the better investment? The Sortino ratio says that the second one is better, and it quantifies the difference.

Calculating Downside Deviation: A Step-by-Step Guide

To calculate downside deviation, start by choosing a minimum acceptable return (MAR), often zero or the risk-free T-bill rate. We'll just use one here for simplicity.

Secondly, we subtract the MAR from each of the returns.

Downside Deviation Input Data
Year Return Return - MAR (1)
2011 -2% -3%
2012 16% 15%
2013 31% 30%
2014 17% 16%
2015 -11% -12%
2016 21% 20%
2017 26% 25%
2018 -3% -4%
2019 38% 37%

Next, isolate the negative numbers (-3, -12, and -4), then square them to get 9, 144, and 16. Sum these squares to find 169. After that, we divide it by the number of observations, 9 in our example, to get about 18.78. Finally, we take the square root of that number to get the downside deviation, which is about 4.33% in this case.

Insights Provided by Downside Deviation

Downside deviation gives you a better idea of how much an investment can lose than standard deviation alone. Standard deviation measures volatility on the upside and the downside, which presents a limited picture. Two investments with the same standard deviations are likely to have different downside deviations.

Downside deviation can also tell you when a "risky" investment with a high standard deviation is likely safer than it looks. Consider an investment that pays 40% half the time and still pays 20% in less successful years. Such an investment would have a much higher standard deviation than one that simply paid 5% every year. However, few people would say that getting paid 5% every year was really safer. Both of these investments would have a downside deviation of zero using 5% as the minimum acceptable return (MAR). That tells us that they are both perfectly safe investments.

Drawbacks and Limitations of Downside Deviation

Downside deviation does not convey any information about upside potential, so it provides an incomplete picture. In the previous example, we learned that an investment with a 50% chance of getting 40% and a 50% chance of getting 20% had the same downside deviation as getting 5% for sure if we use 5% as the minimum acceptable return (MAR). However, the first investment has a much higher upside potential. In fact, it is guaranteed to outperform; the only question is by how much.

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The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.