Question

Investors face various choices regarding what they can invest in, and the choices carry varying amounts of risk. For example, stock prices are much more volatile than bond prices.

What is the typical reason why investors would choose to put their money into an investment with higher risk rather than one with lower risk?
- They want to signal their courage to other investors and scare them away.
- Assuming enough risk in a portfolio qualifies investors for a large government tax credit.
- Riskier investments typically have higher returns.
- Riskier investments are insured by the FDIC.
- They are irrational or are thrill‑seekers.

Answer 1

Riskier investments typically have higher returns.

Step-by-step explanation:

Although investors choose investments for many different reasons, most investors are seeking to earn a return. Ideally, they would like to earn a high return while exposing themselves to little risk, but what typically happens is that companies offering investments with higher risk know that they have to compensate investors for assuming that risk, or else they will not attract sufficient investment. Thus, higher‑risk investments typically offer a higher return, whereas companies offering lower‑risk investments know that they can offer a lower return and still attact investment. For example, a small company in a competitive, fast‑changing industry will typically offer to pay a higher interest rate for its corporate bonds than a large company in a stable industry.

Also, advertising using risque outfits seem to be more aimed at consumers than investors. Advertising for investors is typically rather boring, featuring graphs and numbers. Of course, one may find that the most interesting models of all are economic models. According to the risk-return tradeoff theory, higher risk is associated with greater probability of higher return and lower risk associated with a greater probability of lower return. The trade-off which the investor faces between risk and return while considering investment decision is called risk return trade-off.