What is the relationship between risk and return in finance?

The relationship between risk and return in finance is fundamental to investment theory. Higher risk is generally associated with higher potential returns. This concept is rooted in the idea that investors require compensation for taking on additional risk. When an investment carries a higher level of uncertainty (risk), such as stocks or startups, investors expect a higher return to justify that risk. This principle reflects the risk-return tradeoff, where safer investments provide lower returns, while riskier investments can offer the potential for greater returns.

This relationship can also be observed in various investment scenarios. For instance, government bonds, considered low-risk, typically yield lower returns compared to equities, which are riskier but can potentially provide significant returns, especially over the long term.

Understanding this dynamic is crucial for making informed investment decisions, as it encourages investors to carefully consider their risk tolerance and investment goals when pursuing potential returns.