Final answer:
The statement is generally true; higher risk in stocks is associated with the potential for higher returns. This expectation exists because investors need to be compensated for taking on increased risk.
Step-by-step explanation:
The statement that the higher a stock’s total risk as measured by its standard deviation, the higher its expected return is, in general, true. This concept is rooted in the fundamental principles of financial economics, which state that there is a risk-return tradeoff.
The reason for this is that investors need to be compensated for taking on more risk. Investments such as stocks carry a higher level of uncertainty compared to bonds or savings accounts, and to attract investors to these riskier assets, they must offer the potential for higher returns.
Investors have different levels of risk tolerance and will choose their investments accordingly. A high-risk investment must offer a high expected return to justify the potential for wide swings in performance. If investments with high levels of risk did not offer higher potential rewards, few investors would be willing to invest in them.
Over time, while individual years may see great fluctuations in stock returns, the average return is generally higher for stocks than for bonds or savings accounts.
The fact that stocks can significantly grow or decline in value is what constitutes their risk. Following standard financial theory, as the risk of an investment increases, so should the potential for higher returns, because without these potential returns, the investment would not be appealing to investors. Hence, this relationship is an essential concept in investment and portfolio management.