Risk Curve

What Is the Risk Curve?

The risk curve is a two-layered display that creates a visualization of the relationship between the risk and return of at least one assets.

The risk curve can contain different data points addressing different individual securities or classes of assets. It is utilized to display this data for reasons for mean-variance analysis, which is central to understanding the relative risk and return of various asset classes and categories in portfolios and in investment models, for example, the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT).

Understanding the Risk Curve

The risk curve is utilized to display the relative risk and return of comparative or unique assets. Regularly, the x-pivot (horizontal) implies danger level and the y-hub (vertical) addresses the average or expected return. Generally talking, the risk curve inflatables when the investment being viewed as offers greater risk and returns and contracts when it offers lower risk and returns.

For instance, a relatively "risk free" asset like a 90-day U.S. Treasury bill will be positioned on the lower-left corner on the chart — while a riskier asset, for example, a leveraged ETF or a small-cap growth stock will show up toward the upper right.

Riskier assets with a large number of historical gains and losses will likewise watch out for a higher average expected return. At the end of the day, the tradeoff between an investment's risk and expected return will in general be proportional.

The Risk Curve in MPT and the Efficient Frontier

Modern Portfolio Theory utilizes the risk curve to display the expected benefits of various portfolios across the efficient frontier. Portfolios that lie below the curve or efficient frontier are less than ideal, on the grounds that in view of historical returns, they don't give sufficient return to the level of risk assumed.

Portfolios that cluster to the right below the curve are likewise seen as sub-standard in light of the fact that in view of historical returns, they return proportionately not as much as what might be accessible in different portfolios of comparable risk.

Special Considerations

It ought to be noticed that the data ordinarily utilized in making risk curve models depend on the historical standard deviation of every asset.

For instance, a point on the chart addressing an investment in the S&P 500 Index will consider the level of risk implied by historical variance in returns and furthermore the expected mean (average) return on the index as a whole. The periods that the data address will influence the asset's position on the risk curve. The genuine future risk and return that investors experience proceeding, of course, shifts daily and is obscure.

Features

• The curve means that lower-risk investments, plotted to the left, will carry lesser expected return; those riskier investments, plotted to the right, will have a greater expected return.
• Such a risk curve is the efficient frontier, which is utilized as a cornerstone of Modern Portfolio Theory (MPT) in its course of mean-variance optimization.
• The risk curve is a visual portrayal of the tradeoff among risk and return among investments.