Explain why, in the long run, the rate of return on investment reflects the riskiness of those investments.
The risk-return tradeoff:
The risk-return tradeoff, also known as the risk return spectrum, explains the relationship between returns earned from an investment and the riskiness of that investment. Rational investors consider the level risk involved before injecting capital.
Answer and Explanation:
Generally, risky investments have the potential to make greater returns than less risky investments. Certainly, there is a positive correlation between returns on investments and risk involved. It is, however, important to realize that there is no guarantee that risky investments will actually realize the projected returns. Simply put, high risk investments have the potential to make handsome profits or make great losses in equal measure. Rational investors stand to make profits in line of the risk undertaken.
This relationship between risk and returns explains why the rate of return in the long run describes the level of risk involved.
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from Finance 305: Risk ManagementChapter 3 / Lesson 3