What is the general relationship between risk and return?

• A. Higher risk typically leads to higher potential return
• B. Risk and return are unrelated
• C. Lower risk leads to higher return
• D. Return is independent of risk

Answer: (A)

The risk-return tradeoff explains this relationship: taking on more risk is expected to yield higher potential returns because investors need compensation for the chance of losing money. When an investment has greater uncertainty in its future payoff, it must offer the possibility of bigger gains to attract capital. That’s why higher-risk assets like stocks or entrepreneurial ventures often have higher upside, while lower-risk options like cash or government bonds tend to offer smaller returns. Of course, higher risk doesn’t guarantee higher returns—losses can be substantial, and returns can be unpredictable in the short term—but the general principle is that more risk comes with the potential for more reward. The other ideas—risk and return being unrelated, or lower risk producing higher returns, or return not depending on risk—conflict with this fundamental tradeoff and don’t match how investors price risk.