What is an underlying assumption of the risk-return tradeoff?

The risk-return tradeoff is a fundamental concept in investing that posits a direct relationship between the level of risk an investor is willing to take and the potential returns on an investment. The correct answer reflects the assumption that investors are generally willing to accept higher levels of risk in order to achieve potentially higher returns. This principle suggests that, as the expected returns on an investment increase, so too does the risk associated with that investment.

Investors understand that, while there is the possibility of greater profit, there is also a chance of incurring losses. This tradeoff is crucial for making informed decisions in building an investment portfolio. Investors assess their risk tolerance—personal willingness to take risks—and choose investments that align with their expectations of return, understanding that higher rewards often come with greater uncertainty.

This understanding helps investors weigh their options and decide whether to pursue higher-risk investments for possible greater gains or opt for lower-risk investments that may yield more modest returns.