A surreal illustration of a tightrope walker balancing risk and volatility.

Decoding Investment Risk: How to Balance Loss and Variability for Smarter Choices

Soraya Malik in Business & Economy December 2025 • 5 min read.

"Learn how risk and deviation measures can help you make more informed investment decisions."

Investing always involves risk, but understanding what that risk really means can make all the difference. The concept of risk in finance boils down to two core ideas: first, the possibility of losing money, and second, how much an investment's performance might vary from what you expect. Imagine you're considering two different investments. One seems fairly safe, with steady but modest returns. The other is more volatile, with the potential for higher gains but also bigger losses. How do you compare them? That's where risk measures come in.

Traditionally, measuring risk focused on how spread out the potential outcomes of an investment were. Think of measures like variance, which tells you how much the actual returns might bounce around the average return. But after some major financial crises, people realized that focusing only on variability missed a critical part of the picture: the potential for serious losses. This led to the rise of 'tail-risk' measures like Value at Risk (VaR) and Expected Shortfall (ES), which try to quantify the size of the losses you might experience in the worst-case scenarios.

In a new study, researcher Marcelo Brutti Righi explores how to combine both the 'loss' and the 'variability' aspects of risk into a single, more comprehensive measure. The paper introduces a framework that blends traditional risk measures with deviation measures, aiming to give investors a more complete understanding of their potential exposure. The goal is not just to identify risky investments but to quantify and manage that risk more effectively.

Balancing Act: Combining Risk and Deviation Measures

A surreal illustration of a tightrope walker balancing risk and volatility.

The core idea behind this approach is to create a combined risk measure that considers both the potential for losses (using a standard risk measure) and the degree to which an investment's returns might deviate from expectations (using a deviation measure). Imagine it like this: the risk measure sets a baseline for potential losses, while the deviation measure adds a penalty based on how unpredictable the investment is. This penalty increases the overall risk assessment, making you more aware of the uncertainty involved.

One key element of this approach is a concept called 'Limitedness.' This is basically a check to ensure that the combined risk measure doesn't become overly sensitive or produce nonsensical results. Limitedness ensures that the assessed risk never exceeds the worst-case loss scenario. Think of it as a reality check, keeping the risk measure grounded in the actual potential for losses.

Coherent Risk Measures: These adhere to a set of logical properties, ensuring that the risk assessment is consistent and reliable.
Generalized Deviation Measures: These quantify the variability or spread of potential investment outcomes.
Convex Risk Measures: These reflect the idea that diversification can reduce risk.
Co-monotone Coherent Risk Measures: These apply when investments tend to move in the same direction.
Limitedness: This ensures the risk assessment remains realistic and doesn't exceed potential losses.

The study shows that combining risk and deviation measures in this way can create more robust and reliable risk assessments. The resulting combined measure is shown to maintain key properties of coherent risk measures, ensuring that the risk assessment remains logical and consistent. By considering both loss potential and variability, investors gain a more complete picture of the risks they are taking.

Smarter Investing Through Balanced Risk Assessment

By carefully blending risk and deviation measures, while adhering to principles like Limitedness, investors can move beyond simple measures of loss potential and gain a deeper understanding of the true risks they face. This ultimately leads to more informed decisions and more resilient investment strategies. The key takeaway? Don't just focus on how much you could lose; also consider how predictable your investment's performance is. A balanced approach to risk assessment is key to long-term investment success.

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Everything You Need To Know

What are the two main aspects of investment risk that investors should consider?

Investors should consider the possibility of losing money and the degree to which an investment's performance might vary from expected outcomes. These two aspects are addressed by combining risk measures, which focus on potential losses, with deviation measures, which quantify the variability or spread of potential investment outcomes. Ignoring either aspect can lead to an incomplete understanding of the true risk involved.

Why is it important to consider 'tail-risk' measures like Value at Risk (VaR) and Expected Shortfall (ES) when evaluating investments?

Tail-risk measures such as Value at Risk (VaR) and Expected Shortfall (ES) are crucial because they quantify the potential size of losses in worst-case scenarios. Traditional measures focused primarily on variability around average returns and often overlooked the potential for significant losses. VaR and Expected Shortfall provide a more comprehensive view by focusing on the extreme negative outcomes that can have a severe impact on investment portfolios. This is particularly important because investment returns are often not normally distributed and may contain higher chances of extreme results than average variance measures would suggest.

How does the combination of risk and deviation measures provide a more comprehensive assessment of investment risk?

Combining risk measures with deviation measures offers a more comprehensive assessment by considering both the potential for losses and the unpredictability of an investment's returns. A risk measure, such as Value at Risk (VaR) or Expected Shortfall (ES), sets a baseline for potential losses, while a deviation measure, such as variance, quantifies how much the investment's returns might deviate from expectations. This combination helps investors understand not only the magnitude of potential losses but also the uncertainty associated with the investment, leading to a more informed risk management strategy. The 'Limitedness' principle is applied to ensure the combined risk measure remains grounded and does not exceed the actual worst-case loss scenario.

What is 'Limitedness' in the context of combined risk measures, and why is it important?

'Limitedness' is a crucial principle that ensures a combined risk measure remains realistic and doesn't produce nonsensical results. It acts as a check to ensure the assessed risk never exceeds the worst-case loss scenario. Without Limitedness, the combined risk measure might become overly sensitive to variability, leading to an exaggerated perception of risk that is not aligned with the actual potential for losses. By adhering to Limitedness, investors can have greater confidence that the risk assessment reflects the true potential downside of an investment.

What are Coherent Risk Measures and why are they important for risk assessment?

Coherent Risk Measures adhere to a set of logical properties that ensure risk assessment is consistent and reliable. These properties typically include subadditivity (diversification reduces risk), monotonicity (if one investment always performs better than another, its risk should be no higher), positive homogeneity (scaling an investment scales its risk), and translation invariance (adding cash reduces risk). Adherence to these properties ensures that the risk measure provides a rational and dependable assessment, allowing investors to make informed decisions and avoid potential pitfalls associated with inconsistent or illogical risk evaluations. Other measures that are important are Generalized Deviation Measures, Convex Risk Measures and Co-monotone Coherent Risk Measures.