Downside deviation is a measure of investment risk that focuses on the downside risk or the risk of losses beyond a certain threshold. It is calculated as the square root of the sum of the squared deviations of returns that fall below a specified threshold, divided by the number of observations.
The threshold used for downside deviation can vary, but it is typically set at zero or the minimum acceptable return. By focusing on returns that fall below the threshold, downside deviation provides a more accurate measure of the risk of loss than standard deviation, which treats upside and downside deviations equally.
Downside deviation is commonly used in portfolio optimization and risk management to identify investments or portfolios that have a higher risk of losses and to compare the risk-adjusted returns of different investments or portfolios. A lower downside deviation indicates a lower risk of losses beyond the threshold and, therefore, a more attractive investment or portfolio.