Volatility is the primary component of risk. Volatility exists when outcomes are uncertain. For example, assume you repeatedly flip a coin and this is the payout from each flip:
- You earn $1 if the coin lands on heads (50 percent probability).
- You earn $3 if the coin lands on tails (50 percent probability).
Your expected return for each flip will be $2, the average of $1 and $3. The average absolute deviation from the expected return—that is, the volatility—will be $1. That's because if the coin lands on heads you will earn $1 less than the expected return, and if it lands on tails you will earn $1 more than the expected return.
Now let's analyze a second payout scenario:
- You do not earn anything if the coin lands on heads ...