Chapter Seven

The Reality of Risk

And Why Not to Fear It

Modern portfolio theory gives a technical definition of “risk” that is very different from what we would normally think of risk. It defines risk as volatility calculated by the variance (as measured by the correlation coefficient) of a portfolio’s historical returns. Therefore, a portfolio that is yielding excellent returns to an investor may have a “high-risk” profile if those returns have been volatile over the years.

Investing in emerging markets is not, they say, for the faint of heart. But then again, as the U.S. subprime crisis showed us, neither is investing in developed markets.

Any progress requires risk, since progress is made by moving into the unknown or the unexpected, with the possibility of making mistakes. To make progress we must be able to adapt and diversify so that any one mistake will not destroy our entire portfolio.

If we’ve learned anything in the past few years, it’s that emerging markets are not as risky, in the traditional sense, as they were 10 or 20 years ago. If anything, some of the more mature emerging markets could be said to be even safer than the so-called developed markets, since the growth prospects are so much better. This clearly seems to be the case when you compare emerging market giants such as China and Brazil with developed economies such as Italy and Spain. However, risk in the sense of volatility still exists and because of high velocity trading, derivatives, and more efficient ...

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