3. Risk and Return

Previously, we stated that the standard deviation is a conventional measure of risk. However, the standard deviation considers both positive and negative deviations from the mean. Would you be concerned about getting returns, which are higher than expected? Probably not – this is rather your reward for taking risk, the opportunity to get a return much higher than the one expected. Our concern is obtaining returns on investment that are lower than expected so what we intuitively mean by risk is downside risk, the possibility that our return will turn out well below the one that we expect.

Figure 6: Chinese ideograph for risk

Figure 6 shows the Chinese ideograph for risk or crisis. It is a combination of two ideographs. The one on the left stands for danger and the one on the right stands for opportunity. The Chinese ideograph captures the fact that the flipside of risk is potential reward. There is a positive correlation between risk and reward. The higher the risk that you take, the higher the potential reward and the other way around.