In 1660, Blaise Pascal did some pioneering work on risk. He was dealing with theology, but the implications for the capital markets are unmistakable. His original concern was the expected value of believing in god.
He attempted to convert nebulous uncertainties into calculable probabilities – what we now call risk. His “expected values” are the basis of modern risk theory. Pascal demonstrated that uncertainty is about people, their beliefs and their courage, while calculated risk is based on information, knowledge and credible scenarios.
Together with his colleague, Pierre de Fermat, Pascal came to the conclusion that people are naturally risk averse – the more risk is involved with a particular asset, the greater the return that investors will require as compensation. However, many consumers have a skewed perception of the risk they actually are taking on.
One of the prices we pay as a result of our natural risk aversion is an insurance premium. Equities work in much the same way by offering a risk premium to compensate investors for the higher risk they carry compared to lower risk investments such as cash or government bonds. If the risks of a particular investment are lower or the gains higher than the value of potential losses, people are willing to take chances. This is perfectly rational – in theory.
Risk-Reward Concept is a general concept underlying anything by which a return can be expected. Anytime you invest money into something there is a risk, whether large or small, that you might not get your money back. In turn, you expect a return, which compensates you for bearing this risk. In theory the higher the risk, the more you should receive for holding the investment and the lower the risk, the less you should receive.
For investment securities, we can create a chart with the different types of securities and their associated risk/reward profile. Although this chart is by no means scientific, it provides a guideline that investors can use when picking different investments.