In life it is generally true that greater rewards are wrought through greater risk-taking. The principle of risk-return trade-off suggests that there is a strong positive relationship between the potential rewards of a decision and the risk needed to realize those rewards. In fact, it can be said that with great risk comes the possibility of great reward and great loss.
It is reasonable to assume that investors work toward making decisions that will yield a high return with low risk. Given the choice between two alternatives that carry the same rewards yet one of the alternatives is less risky, most investors will
choose the less risky alternative.
The principle of risk aversion suggests that people, in general, avoid risky choices when alternatives exist that will allow for the same level of benefit. In fact, in the psychology literature, risk aversion is an often-cited construct that captures a significant amount of behavior variability. In financial markets, investors are constantly on the lookout for either the same risk for a larger return, or the same return for lower risk.
Most investors are risk averse, seeking to minimize risk and maximize return. This behavior collectively creates intense rivalry among investors to seek out the best alternatives for themselves because investors are all looking out for their own self-interest. However, how does an investor decide how much risk is too much?
Each investor has a unique combination of goals and knowledge. It is often true that younger investors are advised to invest in riskier assets to realize larger returns and risk the possibility of lower returns because with youth comes plenty of time to correct a course of action before it is too late. Older investors are often advised to risk less and thereby gain less to avoid a bad outcome which can not be corrected or offset by time. The point is that there is no optimal risk-return trade-off sought by investors.
With so many alternatives to choose from and so many levels of risk available, most investors evaluate their situation and take on a level of risk appropriately. Of course, some investors take on too much risk, realize too many bad outcomes and go bankrupt. Such is the game of risk and return.