Final answer:
In a risk-neutral world, the expected return on stocks is the risk-free rate as investors do not demand extra returns for taking on risk. Real-world investments in stocks require a risk premium that is not anticipated in a risk-neutral setup. Understanding these concepts is key to grasping why real-world stocks often offer higher potential returns at greater risk.
Step-by-step explanation:
In the risk-neutral world, the expected return on stocks is a) risk-free rate. This is because in a risk-neutral world, investors are indifferent to risk and hence, the expected return of holding a risky asset, such as stocks, is simply the time value of money, which is the risk-free rate. Stocks in the real world under the Capital Asset Pricing Model (CAPM) demand a premium, known as the risk premium, to compensate investors for taking on additional risk. However, this premium is not expected in a risk-neutral setting.
Investors require a higher average return for holding riskier assets like stocks in order to compensate for the higher degree of risk involved. This concept is essential in understanding why riskier assets typically offer higher returns compared to safer options like bank accounts or bonds. In reality, the actual return on stocks can vary widely, potentially offering much higher or lower returns than the expected rate in any given period.