What is the relationship between risk and return in financial management?

The concept of risk and return is fundamental in financial management, and the relationship between the two is a cornerstone of investment theory. Higher risk is generally associated with higher potential returns because investors demand compensation for taking on additional risk.

When an investor selects an asset, they make a judgment about the potential return they expect to receive based on the risk profile of that asset. Riskier assets, such as stocks or speculative ventures, carry the potential for significant price fluctuations. This volatility can result in high returns if the asset performs well, leading to greater overall rewards.

Conversely, more stable investments, like government bonds or high-grade corporate bonds, tend to offer lower returns. This lower expected return reflects the reduced risk of losing principal, as these types of investments are generally considered safer and more predictable.

In summary, the principle that higher risk is linked to the potential for higher returns is a reflection of the market’s risk-return trade-off, which underlies much of investment strategy and portfolio management.