Erasmus Research Institute of Management (ERIM), Erasmus University Rotterdam (ERIM is the joint researchinstitute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam)
Downside risk, when properly defined and estimated, helps to explain the cross-section of US stock returns. Sorting stocks by a proper estimate of downside market beta leads to a substantially larger cross-sectional spread in average returns than sorting on regular market beta. This result arises despite the fact that downside beta is based on fewer return observations and therefore is more difficult to estimate and predict. The explanatory power of downside risk remains after controlling for other stock characteristics, including firm-level size, value and momentum.