We recently wrote about the attractiveness of an investment. As you will have seen, this assessment has to be done by comparing risk and return provided by an investment. We refer …
We recently wrote about the attractiveness of an investment. As you will have seen, this assessment has to be done by comparing risk and return provided by an investment. We refer to the existence of an “Asset Without Risk” and the risk premium.
In this article, we want to focus our attention on the definition of risk.
What is Risk?
Contrary to what is perceived, risk is not a bad thing to start with. In reality, risk is the uncertainty inherent in an event. This risk may lead to a positive or negative result. But today, we do not know what it is.
As we said, the risk outcome can be either positive or negative. In fact, the Chinese have a character that captures this duality perfectly. They define risk as a hazard and as an opportunity. A danger because it can cause a loss. An opportunity because it can lead us to success.
If you stop to think, humanity has only evolved with the contribution of people who risked, which has led to innovation, to changing the way you view problems. Ultimately, it was the risk they took that brought us to this day.
The Risk in Finance
The discipline of finance seeks to quantify the risk of an investment in a number, using statistical and empirical study. This exercise is intended to capture the default of an event. An expensive name to define the sum of the return differences of an investment compared to the historical average.
What does this mean?
In reality, prices fluctuate every day due to a series of events, which invoke reason or emotion. The idea is to average these variations over a year. Then, we make for every day the difference between the observation of the day and this average. Anyway, a few more steps are missing, but these are the essentials.
What Do These Calculations Serve?
Reducing the risk to a number is a very useful thing, not only because we can establish priorities and fit the investments in our risk profile, but also because we can work on this variable in order to improve the diversification of an investment portfolio. In the future, we will elaborate on diversification.