SOME FINAL WORDS ON RISK

The concept of a risk/return relationship guides investment strategy. The world of investing provides a spectrum of risks and returns. On the low-risk end of the spectrum, you have risk-free U.S. Treasury bills, which provide a minimal return. On the high-risk side, you have stocks, which are more precarious but provide higher average returns.

The concept of the risk premium is fundamental to the pricing of securities. Each class of securities is presumed to carry a different level of risk. Without a higher rate of return, there would be no incentive for investors to put their money into riskier investments.

By understanding the various risks associated with investments, you will be able to understand why certain investments have higher returns. You can then compare the potential risks and returns of an investment using tools such as the Capital Asset Pricing Model (CAPM). The risk-free rate and the risk premium are two of the fundamental components of the relationship between risk and return; understanding these concepts will serve you well as you make investment decisions.

For more information on risk, see our other tutorials on the subject.