Maximum downside exposure (MDE) values the maximum downside to the portfolio. In other words, it tells you the most your portfolio could lose in the event of a catastrophe. As such, MDE obviates the need to worry about the market’s unpredictable swings as it virtually eliminates downside surprises.
The formula is simple and easy to calculate: MDE = unhedged exposure/total portfolio value. For example, if you have half of your funds in inflation-protected cash, and the other half in stocks, you can’t possibly lose more than 50% of your money – that’s your portfolio’s MDE.
The main benefit of MDE is that – unlike probabilistic risk models (such as VaR) – it appropriately factors in all risks to the portfolio without looking at historical (and often erroneous) data and relying on simplistic statistical assumptions that don’t correspond to the real world. This makes MDE a very robust risk management tool.
- ^Marjanovic, Boris. “What Turkeys Can Teach Us About Risk Management”. Seeking Alpha. Seeking Alpha. Retrieved 18 November 2015.
- ^Nocera, Joe. “Risk Mismanagement”. The New York Times. The New York Times. Retrieved 19 November 2015.