Return is the gain or loss from an investment.
Risk is the uncertainty around that return.
Core idea: investors usually require higher expected return to accept higher risk.
Main risk types:
- Default risk: the issuer may fail to pay.
- Inflation risk: future cash flows may buy less than expected.
- Diversifiable risk: company-specific risk that can be reduced in a portfolio.
- Non-diversifiable risk: market-wide risk that remains after diversification.
How risk is commonly measured:
- Standard Deviation of Pool for total portfolio volatility
- Covariance for how two assets move together
- Beta (systematic risk) for sensitivity to market moves
- VIX for expected market volatility
Examples:
- A product recall is mostly diversifiable risk.
- A recession is mostly non-diversifiable risk.