This is the first of a two part series that aims to define risk. Since we live in a world without crystal balls that allow us to clearly see the future, prudent investing is all about the management of risk and expected returns. A problem that both investors and investment advisors face is defining what exactly risk is. As you will see, risk can be many different things, and since risk can be many different things to different people, investors/advisors are faced with deciding which risks are the most important to manage.
The most commonly used academic definition of risk is standard deviation – a measure of volatility. Unfortunately, two investments with similar standard deviations can experience entirely different distribution of returns. While some investments exhibit normal distribution (i.e., the familiar bell curve), others may exhibit characteristics known as kurtosis and skewness. We will first define these terms and then explain why it is important to understand their implications.
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