What does the risk-return tradeoff imply?

The risk-return tradeoff is a foundational concept in investment theory, which asserts that there is a direct relationship between the level of risk associated with an investment and the potential return that the investment can generate. Essentially, if an investor is willing to take on more risk—such as investing in stocks or other volatile assets—there is the potential for higher returns. This is because higher-risk investments tend to be more uncertain, and investors require a premium for taking on that extra risk.

In this framework, as the risk increases, the potential for earning higher returns also increases, reflecting the principle that investors need to be compensated for taking on additional risk. This understanding helps in constructing portfolios that align with the individual risk tolerance and return expectations of investors.