Risk Defined

Pascal
Blaise Pascal

Modern finance began with the realization that risk needed to be measured and managed. In 1654, French mathematicians Blaise Pascal and Pierre de Fermat tried to predict the future outcome of a game of chance. Their questions led to Pascal's Theory of Probability, which quantifies the numerical likelihood of future events. Pascal's Triangle was the foundation for learning how to manage the uncertainty of future outcomes, such as investment returns.

Every investment carries an expected return. The risk of an investment is quantified by the degree to which the returns of the investment deviate from the average return during specific periods of time. Higher risk investments carry a wider range of short-term outcomes but also carry higher expected returns, compensating investors for withstanding short-term volatility. In contrast, investments that have had a narrow range of outcomes over long periods of time are expected to provide more consistent returns with the trade-off of lower returns. For example, an all-bond index portfolio has provided a small but consistent return, while an all-equity index portfolio has provided a larger but more erratic return. Higher expected returns are the reward for an investor's willingness to accept this volatility. In other words, risk is the source of returns and, therefore, should be embraced in appropriate doses.

Step 8Blaise PascalPierre de FermatProbabilityPascal's TriangleTheory of Probability