Home > Topics > Portfolio Management > Introduction to Risk

Introduction to Risk ⚠️

In everyday language, "risk" often means a danger or a hazard. However, in the world of Portfolio Management, risk has a very specific and mathematical meaning. It is not necessarily something "bad"—it is simply the variability of outcomes.

1. Meaning of Risk

In finance, Risk is the possibility that the actual return of an investment will be different from the expected return. It represents the uncertainty regarding the final outcome of an investment.

Important

Finance Definition: Risk is the measure of the variability or dispersion of actual returns around the expected (mean) return.

If a stock is expected to give 10% return but it could actually give 30% or -10%, it is considered risky. An investment that is guaranteed to give exactly 5% (like an FD or Govt Bond) is considered "Risk-Free."

2. Risk vs. Uncertainty

While people often use these terms interchangeably, economists make a clear distinction between them.

Risk

The outcome is unknown, but the probabilities of possible outcomes are known.
Can be measured and managed.
e.g., Playing a game of cards or predicting stock returns based on past data.

Uncertainty

The outcome is unknown, and the probabilities are also unknown.
Cannot be accurately measured or mathematically modeled.
e.g., Predicting the impact of a completely new global event like a mysterious virus.

Loading comparison…

3. Why Does Risk Matter?

Understanding risk is essential because it is the cost of earning a return.

Selection: Investors choose assets based on their "Risk-Return Profile."
Diversification: Knowing the risk allows investors to mix different assets to reduce total risk.
Pricing: Risky assets must offer a higher expected return to attract buyers (this is known as the Risk Premium).

Exam Pattern Questions and Answers

Question 1: "Define Risk in finance and state how it differs from Uncertainty." (5 Marks)

Answer: Definition: In finance, risk refers to the degree of uncertainty or variability in the expected returns from an investment. It is the chance that the actual profit will be lower than expected.

Difference:

Risk: It is a situation where the probabilities of multiple outcomes are known from experience or data. It is measurable.
Uncertainty: It is a situation where the future is unpredictable, and no probabilities can be assigned to the outcomes. It is not measurable.

Summary

Risk = Variability of returns.
The wider the range of possible outcomes, the higher the risk.
Risk can be measured with math; Uncertainty cannot.
Risk is the "price" paid for the "reward" of return.

Quiz Time! 🎯

Test Your Knowledge

Question 1 of 4

1. In finance, risk is defined as:

The certainty of loss

The variability of actual returns from expected returns

The guarantee of high profit

The total amount of investment

Loading quiz…