What does the risk-return tradeoff principle imply about higher-risk investments?

The risk-return tradeoff principle suggests that higher-risk investments inherently come with the potential for higher returns. This principle is fundamental in finance and investing, indicating that if an investor is willing to take on more risk — such as investing in stocks, startups, or other volatile assets — they can expect to be compensated with a greater potential for profit.

This relationship exists because investors need an incentive to engage in investments that have a higher likelihood of loss. Thus, higher returns are seen as a reward for bearing that additional risk. For example, while government bonds might provide a lower return due to their perceived lower risk, equities might yield higher returns, albeit with greater volatility and risk of loss.

This perspective is crucial for investors when constructing their portfolios, allowing them to align their risk tolerance with their return expectations. Understanding this tradeoff helps investors make informed decisions about where to allocate their resources, balancing their desire for growth with their appetite for risk.