Downside risk and leverage: Risk illusion redux
Most real estate investors lack an intuitive but analytically rigorous way to think about downside risk. Ignoring downside risk can impair performance, especially in the presence of leverage, and promote risk illusion at the deal and portfolio levels.
A basic empirical fact and working assumption in finance theory is that there is a tradeoff between risk and return. The standard deviation, which is a widely used measure of risk, may not satisfactorily address investors’ concern about downside risk.
Downside risk and shortfall loss
An intuitive and practical way to think about downside risk is to specify a minimum return threshold that the investor seeks to exceed with some probability, say, 90 percent. We might want to increase the confidence level, but to do so will require a lower threshold or return floor. Greater certainty comes at the price of a lower floor.<