Ironically, it is uncertainty that creates the potential for higher returns. How? Because of the risk/return trade-off.
Every investor wants the highest assured return possible. But as we have seen, returns aren't certain, and different investors have varying degrees of uncertainty that they are willing to accept. In fact, each investor seeks the highest possible return at the level of uncertainty, or risk, that he is willing to accept.
In a competitive marketplace, this results in a trade-off: Low levels of uncertainty (low risk) are the most desirable, and are therefore associated with low potential returns. High levels of uncertainty (high risk) are the most undesirable, and are therefore associated with high potential returns.
Over the last 68 years, stocks have produced returns that average 11.0% annually; intermediate-term bonds have averaged 5.7% annually and short-term Treasury bills have averaged 4.2% annually. These returns reflect the risk/return trade-off.
The trade-off, however, exists on average, not in every single instance: Remember, it's the uncertainty that's the risk. As an investor, you must analyze each investment, comparing the potential returns with the risks. On average, the potential returns from an investment should compensate you for the level of risk undertaken. If they do not—for instance, low potential returns associated with high risk—you should not make the investment.
The trade-off also serves as a warning flag—high potential returns usually flag high risks, even when those risks are not obvious at first glance. For instance, even higher-yielding certificates of deposit need to be viewed with caution and skepticism.
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