Definitions and Basics

Risk-Return Tradeoff, from Investopedia.com

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses….

Risk and Reward Introduction at Khan Academy

In the News and Examples

Nassim Nicholas Taleb on the Precautionary Principle and Genetically Modified Organisms, EconTalk podcast, January 19, 2015.

Nassim Nicholas Taleb, author of AntifragileBlack Swan, and Fooled by Randomness, talks with EconTalk host Russ Roberts about a recent co-authored paper on the risks of genetically modified organisms (GMOs) and the use of the Precautionary Principle. Taleb contrasts harm with ruin and explains how the differences imply different rules of behavior when dealing with the risk of each. Taleb argues that when considering the riskiness of GMOs, the right understanding of statistics is more valuable than expertise in biology or genetics. The central issue that pervades the conversation is how to cope with a small non-negligible risk of catastrophe.

Rebonato on Risk Management and the Crisis, EconTalk podcast, June 8, 2009.

Riccardo Rebonato of the Royal Bank of Scotland and author of Plight of the Fortune Tellers talks with EconTalk host Russ Roberts about the challenges of measuring risk and making decisions and creating regulation in the face of risk and uncertainty. Rebonato’s book, written before the crisis, argues that risk managers often overestimate the reliability of the measures they use to assess risk. In this conversation, Rebonato applies these ideas to the crisis and to the challenges of designing effective regulation.

Hansen on Risk, Ambiguity, and Measurement, EconTalk podcast. June 30, 2014.

Lars Peter Hansen of the University of Chicago and Nobel Laureate in economics, talks to EconTalk host Russ Roberts about the power and limits of economic models and quantitative methods. Hanson defends the value of models while recognizing their limitations. The two also discuss quantifying systemic financial risk, how our understanding of financial markets has changed, the nature of risk, and areas of economics that Hanson believes are ripe for further research.

A Little History: Primary Sources and References

Harry Markowitz, biography from the Concise Encyclopedia of Economics

In 1990, U.S. economists Harry Markowitz, William F. Sharpe, and Merton H. Miller shared the Nobel Prize for their contributions to financial economics. Their contributions, in fact, were what started financial economics as a separate field of study. In the early fifties Markowitz developed portfolio theory, which looks at how investment returns can be optimized. Economists had long understood the common sense of diversifying a portfolio; the expression “don’t put all your eggs in one basket” has been around for a long time. But Markowitz showed how to measure the risk of various securities and how to combine them in a portfolio to get the maximum return for a given risk….

William Sharpe, biography from the Concise Encyclopedia of Economics

In the sixties Sharpe, taking off from Markowitz’s portfolio theory, developed the Capital Asset Pricing Model (CAPM). One implication of this model was that a single mix of risky assets fits in every investor’s portfolio. Those who want a high return hold a portfolio heavily weighted with the risky asset; those who want a low return hold a portfolio heavily weighted with a riskless asset, such as an insured bank deposit….

Advanced Resources

Risk, Uncertainty, and Profit, by Frank Knight on Econlib

Ross Emmett, A Century of Risk, Uncertainty and Profit, a Liberty Classic at Econlib, December 2018.

Knight’s approach in Risk, Uncertainty and Profit suggested that a core set of economic ideas were necessary to learn in order to understand any economic phenomena, challenging the prevailing institutionalist orthodoxy. Equally important, Knight’s contributions to the theory of perfect competition staked out a position different than those of existing theoretical traditions. While it shared much in common with both the Marshallian and Austrian traditions, Knight also provided a unique explanation for business profit. This explanation reflected modernist tendencies to emphasize uncertainty, while simultaneously grounding the explanation on the willingness of the entrepreneur to make judgments in the midst of uncertainty.

 

Related Topics

Financial Markets

Futures and Options Markets

Insurance

Saving and Investing

Budget Deficits and Public Debt

Entrepreneurs

Profit

Risk and Safety