Your friend Ricky took a finance class and learned about the risk-retu

Your friend Ricky took a finance class and learned about the risk-return trade-off. Wanting a high return, Ricky
invested in a risky, start-up technology company. A year later the company went bankrupt and Ricky lost his
entire investment.

Ricky is furious with his finance professor for misleading him, claiming he was taught that
higher return goes with higher risk. Explain how Ricky misinterpreted the risk-return trade-off.

ANSWER

The risk-return trade-off deals with expected returns, not actual returns. For risk averse investors, higher expected
returns are required before they will take on higher risks. However, higher expected returns do not always materialize.
Risky projects sometimes result in lower actual returns. This is what makes them risky.