What is indicated by the risk-reward rule?

The risk-reward rule fundamentally asserts that there is a direct relationship between risk and expected return. This principle means that investments that carry higher levels of risk typically offer the potential for higher returns. Investors understand that while they may face greater chances of loss with riskier assets, the potential rewards can also be substantial, justifying their willingness to accept the risk involved.

This concept is crucial for investors when constructing a portfolio and making decisions about asset allocation. For example, equities and high-yield bonds are seen as riskier investments compared to government bonds or savings accounts, but they provide opportunities for higher returns over time. This attracts those investors who can tolerate fluctuations and uncertainties in pursuit of greater earnings.

In contrast, options that present a low-risk profile generally yield lower returns. This is why the risk-reward principle is a foundational component of investment strategy; it shapes how investors approach their choice of assets based on their risk tolerance and financial goals. Thus, the assertion that higher risk correlates with higher potential returns firmly aligns with this widely accepted investment theory.