2.1 Risk and Return Fundamentals

The pricing of assets typically involves assessing two components: return and risk. If you know the timing and amount of future values (returns) and you know their likelihood (risk), you can compute their present value. Risk diminishes the value of future returns. Experience shows that human beings, including investors, seek to avoid risk and prefer certain returns over uncertain ones.

There are many methods for valuing assets -- that is, for valuing risky returns. Using insights derived from game theory, it is possible to value assets using procedures (or algorithms) in which parties express their risk/return evaluations to determine value. In addition, using observations on how we behave in the face of risks (such as buying cars or taking dangerous jobs), it is possible to compute how much we value our own lives.

2.1.1 - Returns

What is interest? Fundamental to valuation is the practice (observed throughout history) that the those who permit another to use their money demand a return—or "interest." What is interest? Simply put, it is the amount charged to use money for a given period. (More 2.1.1>>)

2.1.2 - Risk

Risk is often understood as the possibility of loss. But risk, in financial terms, is really a way to talk about a range of possibilities -- the variability of returns. In short, risk is a way to describe degrees of uncertainty. (More 2.1.2>>)

2.1.3 - Risk aversion

It is often said that investors are risk averse. What does this mean? Risk aversion depends on people's financial circumstances and the range of possibilities. Our natural risk aversion shows up in policy decisions about approving new drugs or reviewing corporate decision-making. (More 2.1.3>>)

2.1.4 - Fair division procedure

We all value things differently. For example, some of us prefer a house with a view, others of us prefer one with modern plumbing, yet others one with a good location. Typically, markets allocate assets to those who value them most. But sometimes markets are unavailable or are expensive to replicate. (More 2.1.4>>)

2.1.5 Value of life

What is the value of human life? Can it be computed or is life incalculably valuable? Perhaps, it is a cruel question. But we behave in ways that reflect how much we value our existence. These implicit valuations can aid policy decisions, like requiring air bags for cars or accepting some morbidity for new drugs that are potentially beneficial. (More 2.1.5>>)

Weather is a risk - sometimes fair and sometimes foul.