What term describes the relationship where higher risk can lead to higher potential returns?

• A. Diversification
• B. Risk-return tradeoff
• C. Time value of money
• D. Risk tolerance

Answer: (B)

The idea that taking on more risk can lead to higher potential returns is the risk-return tradeoff. In investing, riskier assets offer the chance of bigger gains, but also bigger losses, so investors expect to be rewarded with higher returns for bearing that extra risk. Safer options tend to provide smaller, more predictable returns, with less volatility.

Diversification focuses on spreading investments to reduce overall risk, not the inherent link between risk and return. Time value of money explains why money available now is worth more than the same amount in the future, due to earning potential, not the risk-return relationship. Risk tolerance is about how much risk an individual is willing to accept, which informs choices within the risk-return framework but doesn’t define the relationship itself.