Which principle does the risk-return tradeoff illustrate?

The risk-return tradeoff illustrates the principle that potential returns on an investment increase as the associated risk increases. This fundamental concept in finance demonstrates that investors must accept a higher level of risk if they seek the potential for greater returns.

Investments that are perceived as riskier generally offer the prospect of higher returns to compensate investors for the additional uncertainties and potential losses involved. For example, stocks tend to have a much higher potential return compared to government bonds, which are considered safer. This relationship encourages investors to assess their risk tolerance, making informed decisions about how much risk they are willing to take on to pursue higher potential gains.

Understanding the risk-return tradeoff is crucial for effective investment strategy and portfolio management, as it enables investors to align their investment choices with their financial goals and risk appetite.