A comparative study of downside risk and volatility in asset allocation

Risk management plays a central role in portfolio theory. In order to capture the risk-reward profile of an investor, it is important to quantify the investor’s perception of risk as accurately as possible. The paper studies in this work how two different measures of risk can affect the performance of asset allocation models. It analyzes, both from the conceptual and computational points of view, how downside risk compares to the most traditional risk measure, volatility, when used in optimization models for asset allocation. Numerical examples are provided in order to illustrate the advantages/disadvantages of each alternative, including a historical analysis of several asset allocation strategies.