Advanced Diploma of Financial Planning (ADFP) Practice Test

What kind of relationship exists between risk and return?

1. Direct

2. Indirect

3. Inversely related

4. No correlation

The correct answer is: Indirect

The relationship between risk and return is fundamentally recognized as direct. This means that as the potential return on an investment increases, the level of risk associated with that investment typically increases as well. For example, investments in equities or real estate can offer higher returns compared to fixed income securities like bonds. However, these higher-return investments usually come with greater volatility and uncertainty, which translates to higher risk. This principle is often summarized in the risk-return tradeoff concept, where investors are generally rewarded for taking on more risk. In contrast to the chosen answer, an indirect or inverse relationship does not accurately capture this fundamental principle. An indirect relationship would imply that as one factor increases, the other decreases, which does not reflect the reality of investment dynamics. Similarly, the term "inversely related" suggests that a decrease in one variable would lead to an increase in the other, which contradicts the established understanding of how risk and return interact. Lastly, the notion of no correlation is also incorrect because it disregards the well-documented correlation observed in financial theories and investment practices. Overall, recognizing that risk and return are directly related is crucial for making informed investment decisions and understanding market behaviors.