What does Modern Portfolio Theory (MPT) describe risk as?

Modern Portfolio Theory (MPT) describes risk as the degree to which investment returns deviate from expected returns. This conceptualization of risk highlights the variability and uncertainty of returns, emphasizing that risk is not merely linked to the potential for loss but is fundamentally about the fluctuations around expected performance. MPT suggests that investors should not only consider the average returns of an investment but also how much those returns might vary over time, as this volatility influences decision-making and portfolio construction.

In MPT, the focus is on understanding how different assets behave in relation to one another and how they contribute to the overall risk and return of a portfolio. By diversifying investments, an investor can potentially reduce the overall risk while aiming for a specific return. This understanding of risk as a deviation from expected returns is central to MPT’s premise of achieving optimal asset allocation to maximize returns for a given level of risk tolerance.

The other options, while related to the general concept of risk, do not capture the essence of MPT’s definition. For instance, viewing risk as the potential for earning higher returns does not align with MPT's analytical approach, which is more focused on variance and distribution rather than potential upside. Similarly, considering risk as the likelihood of portfolio loss or based solely