What does the risk-return tradeoff principle state?

The risk-return tradeoff principle articulates the fundamental relationship between the potential return on an investment and the risk associated with that investment. Specifically, it states that as the level of risk increases, so does the potential for higher returns. This is grounded in the understanding that investors typically expect to receive greater rewards for taking on increased risk. For example, investments in stocks generally present higher risk than bonds, but they also offer the potential for higher returns over the long term.

This principle is crucial for investment strategy and decision-making, as it helps investors align their risk tolerance with their investment goals. Understanding that not all higher-risk investments will guarantee higher returns, investors can make more informed choices by balancing their portfolio between risky and safer assets to achieve their desired financial outcome.