Risk Curve

Why do people take risk? For bungee jumpers: just to feel alive, by feeling close to death. For investors: because big profits come with big risks (when they do well). The more you can stand to risk, the more you can stand to make...or lose.

A risk curve shows the tradeoffs between taking on risk and assets. Think of investment returns, or whatever payoff value, on the y-axis. The x-axis is cumulative probability of risk—basically, a scale between 0% and 100% of risk. The greater the risk, the greater the average returns could be, so the risk curve slopes upward. You could get a low-risk, short-term bond, which would curve toward the bottom-left: low risk = low gains. Or you could buy some shares of a risky startup, which would be high and to the right: high risk = high potential gains.

The risk curves lives in the home of Modern Portfolio Theory (MPT), which aims to maximize returns while minimizing risk. MPT relies on the risk curve to show investors potential benefits across the efficient frontier, getting the most bang for your buck.

Risk curves are hard to make accurately, since we’re only speculating on how risky something is. We don’t actually know if it was risky or not until something happens...or doesn’t. Historical standard deviation helps figure out what a reasonable assumption of risk could be for a given investment though.