In the context of business, the term “downside” refers to the set of risks associated with a particular action. In the world of investment, this is known as a downside risk. A downside risk involves the chances that a stock’s price will drop after it has been purchased, as well as the extent of this possible decline.
Several methods may be used in order to assess the downside risk of a particular stock. One strategy involves looking at the history of the price-earnings ratio of stocks and determining whether they are currently selling at the low or high end of this range. Stocks selling on the lower end of the ratio tend to seem more reliable, whereas those with a history of high ratios may appear to be riskier.
To address downside risks, a set of strategies known as downside protection must be employed. Downside protection seeks to remove, or at least lessen the possible effects of downside risks. One example of this is having a protective put on a stock, which will allow the stock to be sold for the protective put’s strike price, should the share price drop drastically.
While investors do need to determine the downside risks of stocks before they make any purchasing decisions, it is important to note that this is not the only factor that comes into play. Decisions will still have to be made based on the investor’s objectives. For instance, an investor may choose to purchase stocks with higher downside risk if he believes that there is also a better chance of price appreciation.