Could someone please explain the solution in a better way? The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments with higher non-diversifiable risk should expect to earn: A) lower rates of return. B) rates of return equal to the market. C) unknown-depends on individual utility curves. D) higher rates of return. Your answer: B was incorrect. The correct answer was D) higher rates of return. Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk (Es) and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping.
It is D because risk-averse individuals need a risk premium to compensate them of the additional risk they are taking. This is why the CML (relationship between E® and risk (sigma) is upward. Read carefully the question 