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What relation do we generally observe between risk and return when we examine historical returns?

Question:

What relation do we generally observe between risk and return when we examine historical returns?

Risk-return Tradeoff:

This question calls for a basic understanding of the risk-return tradeoff theory, which describes the relationship between the potential return on investments and their inherent risk.

Answer and Explanation:

In examining historical returns, one can generally observe a direct relationship between risk and return. Low levels of risk, generally characterized as uncertainty, are associated with relatively low potential returns. Conversely, high levels of risk are associated with relatively high potential returns. This is because an investor seeking an increasingly high rate of return must expose himself to an increasingly large amount of risk (uncertainty), typically defined as the standard deviation of returns.

The relationship can be clearly observed by comparing the returns of U.S. Treasury bills (generally considered to be risk-free), investment grade corporate bonds (which reflect credit and interest rate risk), and domestic equities (which reflect highly uncertain earnings and cash flows and a much higher degree of volatility than the other investments listed).


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Investment Risks: Definition & Types

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