Chartered Financial Analyst (CFA) Level 1 Test 2025 – 400 Free Practice Questions to Pass the Exam

The risk-return trade-off refers to the fundamental principle in finance that suggests there is a direct relationship between the level of risk an investor is willing to take and the potential returns they can expect from that investment. In simple terms, the higher the risk associated with an investment, the greater the potential return, which is why option A is correct. This concept is essential for investors when making decisions about where to allocate their capital, as it provides a framework for understanding how different investment options can yield varying outcomes based on their inherent risks.

For example, equities often present higher risks compared to fixed-income securities but can offer correspondingly higher returns over the long term. This principle urges investors to assess their own risk tolerance and investment goals in order to build a portfolio that balances their desire for growth with their comfort level regarding potential losses.

In contrast, the other options do not accurately capture this critical financial principle. For instance, the notion that returns decrease as risk increases contradicts the foundational understanding of the risk-return relationship. Similarly, options that refer to balancing debt and equity or diversifying investments address other aspects of investment strategy but do not define the risk-return trade-off itself.