Risk return trade-off

Rational investors are said to be risk-averse.

That is, given two investments with equal returns, an investor would select the one with the lowest risk. Therefore investors need to be compensated with additional returns for taking on additional risks.

Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to this trade-off, investments can only generate higher profits if there is a risk that they might be lost.

In the case of the above diagram, investment A is more volatile than investment B, but exhibits a higher return over time.

According to this theory, a risk-free investment with zero risk of capital loss should earn no more or less than the risk-free rate, or the minimum return an investor should expect on an investment.