One of the central elements in modern finance theory is that of a risk-return tradeoff. The idea is simply that investors are risk averse, and accordingly must be paid to incur risk. T here is, then, a constant trade-off in the investment world: safe investments carry low return, high-return investments aren’t so safe. Fortunately, this conforms with almost everyone’s intuitions. What exactly is risk, though? Yes, we have an intuitive idea. The guy jumping out of an airplane is taking a risk that the appreciative audience standing on firm ground below is not. Further, if he has neglected to check his gear properly he is taking an extra, unwarranted, risk. But we can be a good deal more specific about what the word means in the world of investments. It means the size of the standard deviation of return. It means the width of that bell curve we've discussed in earlier posts. Standard Deviation A standard deviation is the “average distance from ...