What is Risk? Part 1

Posted on 05. Sep, 2008 by Kyle Waller

Risk of an investor’s portfolio can have several meanings.  However, in highly diversified portfolios the only meaningful risk is the risk that an investor will have less money in their portfolios at the end of their planned time horizon.  So, for our purposes now we will define risk as the amount of volatility and variability of the Capital Markets (the stock and bond markets).

All investments have fluctuations.  Houses, property, oil, and of course stocks and bonds.  We call the amount of variability standard deviation (variance is the square root of standard deviation), remember high school statistics class.  So, we measure the fluctuations of our portfolios and the stock and bond market by standard deviation.

Since all assets have fluctuations, we define more risky assets as having higher fluctuations about the mean or higher standard deviation.  Therefore in highly diversified portfolios, we can minimize the amount of risk of a portfolio by adding assets that have different fluctuations at different times or low statistical correlation.  This is a very simple version of Modern Portfolio Theory (MPT), which Harry Markowitz won a Nobel Prize for and detailed in his book, “Portfolio Selection”.  Using MPT one can ‘optimize’ a portfolio, minimizing risk and maximizing expected return.

This can give a portfolio made of many assets lower risk than each individual asset.