Understanding the Investment Risk Pyramid
Draw a pyramid on a scrap of paper, then look at the image. You'll see that your pyramid is large at its base, smaller in the middle and very small at the summit. This model, which has been around for thousands of years, can also be used when it comes to assessing your investments.
When you use the investment risk pyramid strategy to decide how to invest money, you're building a portfolio that includes many low-risk assets, some medium-risk growth investments and a few high-risk speculative investments. Here's how it works.
An investment risk pyramid doesn't tell you what particular stocks and bonds to buy. Rather, it's an asset allocation tool. Asset allocation means deciding what percentage of your overall assets should go into lower-risk safe securities, how much should go into growth investments that carry some risk, and what portion you can afford to put into high-risk ventures.
You don't usually make an investment allocation decision that stays the same throughout your lifetime. Young people have time to take on more risk, but most investors prefer less risk as they approach their retirement years or when world markets are in turmoil.
The Base of the Pyramid: Low-Risk Assets
The lowest-risk investments you can find are cash and cash equivalents that have set rates of return you can count on. These include government bonds, AAA-rated bonds and certificates of deposit (CDs). All U.S. government-guaranteed investments fall into this conservative category.
This part of the investment plan is represented by the pyramid's wide base, since low-risk investments should generally constitute the bulk of your portfolio.
The Middle of the Pyramid: Medium-Risk Investments
The middle area of the pyramid represents the assets that are allocated to medium-risk investments. While you can't bet the farm on a set percentage return rate for these assets, they generally offer a stable return and the possibility of capital appreciation. That means that these investments, in addition to generating income, may also increase in value themselves.
The classic example of a medium-risk investment is a good growth stock. It is likely to generate income in the form of annual dividends, and the value of the stock itself can also rise.
The Peak of the Pyramid: High-Risk Investments
The risk/reward concept of investing suggests that the more risk you have of losing money in a particular investment, the higher return you should get. The peak of the pyramid — its smallest area — represents these high-risk investments. Because of their speculative nature, you should only allocate money to high-risk investments if you can afford to lose them without life-changing repercussions.
The peak is not the place to store money you intend to use the following year to purchase a home or to invest your grandmother's life savings. High-risk/high-reward investments include stock options, commodities and even your baseball card collection.