Which statement reflects the core investment principle of risk and return?

• A. Diversification can manage risk.
• B. Higher potential return typically comes with higher risk; diversification can manage risk.
• C. Diversification increases risk without reducing expected return.
• D. Higher risk guarantees higher returns.

Answer: (B)

The risk-return trade-off is the core idea: investors typically expect higher potential returns for taking on more risk, so risk and return move together. Diversification helps manage risk by spreading investments across assets, reducing the impact of any one investment's poor performance, without necessarily reducing the expected return. Of course, diversification can’t eliminate all risk—particularly systematic market risk—but it makes the trade-off more favorable by lowering risk while preserving the potential for higher returns.

The other statements fall short because one only mentions diversification without tying it to the return aspect, another suggests diversification increases risk, and the last claims that higher risk guarantees higher returns, which isn’t true.