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Modern portfolio theory formalizes the risk-return relationship,
assuming that investors make decisions based solely on the
mean and variance of the return distribution. Further, the
return distribution is assumed symmetric implying that low
returns are as likely as high returns. However, studies
have revealed strong empirical evidence that return distributions
are not symmetric, which has led to the criticism of standard
deviation as a measure of risk. Standard deviation treats
positive and negative returns equally. In practice, however,
risk is viewed differently depending on the perception of
the degree of risk associated with the investment. Most
investors' view of risk is related to the downside of the
return distribution suggesting that risk may be an asymmetric
phenomenon. It is widely argued that investors usually do
not view returns above a threshold as bad, giving rise to
the concept of downside risk. Therefore, given the evidence
of asymmetry in stock return distributions the use of the
market model to explain asset price variation is questionable.
In other words, the adequacy of the Capital Asset Pricing
Model (CAPM) beta as a measure of systematic risk is a concern.
An alternative measure of systematic risk is the downside
beta derived from the concepts of Mean-Lower Partial Moment
(M-LPM) framework (Bawa and Lindenberg, 1977).
Downside risk has received much attention from practitioners
as well as academics. Ang et al. (2006) highlight that bearing
downside risk is not simply the compensation for CAPM beta
risk. Further, they reveal that bearing downside risk may
not be explained by co-skewness or liquidity risk, or by
size, value and momentum characteristics. |
