What is the relationship between risk and return?

The relationship between risk and return is fundamentally based on the principle that higher levels of risk are often associated with the potential for higher returns. Investors need to be compensated with greater potential returns for accepting increased risk. This principle is rooted in the idea that as the uncertainty and potential for loss associated with an investment increases, so too must the expected returns to entice investors to take on that additional risk.

For example, investments in stocks are generally considered riskier than investments in government bonds. Therefore, stocks typically offer higher potential returns to justify the increased risk involved. This relationship underscores a key concept in finance: the risk-return tradeoff, emphasizing that prudent investors weigh their risk tolerance against the expected return from an investment.

Understanding this principle is crucial for making informed investment decisions, as it helps investors align their portfolio choices with their risk preferences and financial goals.