What is the Risk/Return Trade-Off

There are investments which have the potential for very high returns, but they will always be that much riskier than the lower-yielding alternatives, and this is part of the risk/return trade-off.

The relationship between risk and return is a positive linear relationship in most theoretical depictions, and if an investor seeks greater returns, he or she will have to take on greater risk. This is called the risk/return trade-off. For more stability and less risk, an investor will have to sacrifice some potential returns.

High yield bonds are more susceptible to risk, and in that case the yield paid out by the company issuing them reflects the need to compensate investors for taking on the amount of risk present. Ratings institutions attempt to verify the amount of risk present with ratings systems that evaluate a company’s potential to default on a bond.

This extra amount paid per risk is known as the risk premium, and investors will need to be compensated for taking on risk, or, more theoretically, for allowing the risk to be transferred to them. This relationship is found all throughout economics.

In banking and elsewhere, the rate of interest charged on various instruments tends to be proportional to the amount of risk being taken. This relationship is part of all other non-fixed assets and securities as well.

Efficient Market Hypothesis are examples of the way this risk/return trade-off can be visualized and expounded upon.