What does that mean, exactly? It starts with the idea that all securities have an inherent level of risk. Next, all securities have an expected return, based on several scenarios. Finally, using statistical measures, one must weigh the risk against the return and find the asset that has the best return per unit of risk assumed.

Risk

There are many different forms of risk in the market place. These factors come in all shapes and sizes, and sometimes surprise many people. They don't pop out of nowhere, but are sometimes difficult to see.

For example, business risk is the risk inherent in a firm's business operations. A firm may operate in a niche market that relies on the economy to be running along smoothly. This could be a luxury niche or something of that nature. One example could be a high priced restaurant.

During good times, they have great revenues because people feel they are wealthy enough to celebrate. However, during economic hardship, trips to fancy restaurants are usually the first to go. It would be said that this firm's business risk is positively correlated with the overall cycle of the economy. Sometimes a firm can be negatively correlated, such as cheap substitute products. When times are hard, people usually avoid buying expensive name brand items. That is when store brand or no name brands become more attractive.

Business risk can be eliminated by investing in many different firms in different fields. It is diversifiable. This is why the phrase "diversify your portfolio" is such a hot button. It is rooted in real, financial logic.

Return

Return is the percent amount of money that you get back for every unit you invest. If you invest $100 and get back $105, you would have a 5% return. This is a pretty simple concept, but predicting return can get pretty tricky.

Let's say you expect an asset to appreciate 15% in the next year. You have 60% confidence that this will happen. However, if there is a recession it will only appreciate 1%, and if there is an economic boom it will appreciate 20%. There is a 20% chance of either an economic boom or a recession over the next year.

These numbers and probabilities may not seem entirely believable, but try for the sake of argument. To compute an expected return for this security, all you have to do is multiply each expected return by the probability of that state of nature.

The equation would look like this: (15%)(.6) + (1%)(.2) + (20%)(.2) = 13.2%

This is the expected return for this security. Although it will never be exactly 13.2%, given this model, this is what is used when calculating a risk adjusted return. It is most probable that the return will be 15% or greater, but there is a 20% chance that it could be 1%. Therefore, 13.2% is the best number to use when calculating an expectation.

Deciding which asset to buy

The next step is deciding which asset to buy. This usually involves some statistical measures, which I won't get into here. Terms like standard deviation, correlation and covariance are usually used when describing portfolio management. All of these terms have to do with the basic idea that you need more expected return per additional unit of risk. If you can grasp that basic concept, then you are well on your way to getting a better understanding of finance.