Why do investors expect higher returns if they take more risk?

Investors expect higher returns when taking on more risk primarily to cover potential losses associated with riskier investments. The fundamental principle of risk and return in finance is that higher potential returns are only justified by the assumption of greater risk. When an investor decides to invest in assets that are more volatile or uncertain – such as stocks, startups, or high-yield bonds – they do so with the understanding that these investments carry a higher likelihood of not just losses but significant fluctuations in value.

By demanding higher returns, investors seek compensation for the uncertainty and potential adverse outcomes that come from holding riskier assets. This expectation serves as an incentive, encouraging them to allocate capital to investments that have not only a possibility of growth but also downside risks, thereby aligning their potential rewards with the risks being undertaken.

In contrast, motives such as compliance with market regulations or merely following trends do not directly express the relationship between risk and expected returns. While beating inflation can be a component of an investor's goals, it doesn't capture the essence of the risk-return trade-off. The critical takeaway is that the desire for higher returns in exchange for taking on more risk underlines many investment decisions in market behavior.