Which of the following statements is true regarding risk and expected returns?

The relationship between risk and expected returns is foundational in finance and can be understood through the principle of risk-return tradeoff. This principle states that as the level of risk increases, the potential for higher returns also increases. Investors typically demand a higher return for taking on more risk; they need to be compensated for the uncertainty associated with riskier investments.

In the context of the financial markets, assets that are perceived to be riskier—such as stocks, commodities, or startup ventures—usually offer higher expected returns to attract investors. Conversely, lower-risk investments, like government bonds or other secured assets, generally provide lower expected returns. This positive relationship is evident when examining various investment options and the historical performance of various asset classes.

A common metric that illustrates this relationship is the Capital Asset Pricing Model (CAPM), which demonstrates that expected returns are proportional to the systemic risk measured by beta. This correlation reinforces the idea that taking on additional risk in a portfolio should yield a corresponding increase in the expected returns, validating the choice of stating that they are positively related.