Risk-return Spectrum - Why The Progression?

Why The Progression?

The existence of risk causes the need to incur a number of expenses. For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress. For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment. Risk is therefore something that must be compensated for, and the more risk the more compensation required.

If an investment had a high return with low risk, eventually everyone would want to invest there. That action would drive down the actual rate of return achieved, until it reached the rate of return the market deems commensurate with the level of risk. Similarly, if an investment had a low return with high risk, all the present investors would want to leave that investment, which would then increase the actual return until again it reached the rate of return the market deems commensurate with the level of risk. That part of total returns which sets this appropriate level is called the risk premium.