What Is an investment risk pyramid - a detailed guide

We often like hearing that our investments are risk-free. But the truth is, such claims are just a farce. True, the level of risk can differ from one investment to another, but the risk is always present.

For the longest time, investors have used the investment risk pyramid to develop their investment portfolios to help them grow their wealth. By using the pyramid, it will help them diversify their investment portfolio.

As an asset allocation tool, it provides a mechanism for choosing investments based on the risk levels of each invested asset.

So how would a financial advisor use the investment risk pyramid?

Say, an investor named Jack went to his financial advisor, Mr Roth, about how to best position his portfolio. The 45-year-old tells Mr Roth he works hard for his money at the farm and doesn’t want to risk his hard-earned money by taking a lot of risks.

Considering his goals, risk appetite and time horizon, Mr Roth recommends Jack use an investment pyramid strategy. He proposes to allocate the assets this way

60% in treasury bonds and money market securities

30% in mutual funds invested in corporate stocks and government bonds

10% in speculative assets like futures and commodities

This way, he takes little risks and can still earn a profit. So let’s understand the investment risk pyramid a bit more.

How does an investment risk pyramid work?

A pyramid is shaped with the bottom wide and keeps narrowing on its way to the top until it reaches its peak. Similarly, asset allocation and risk appetite have a structure of a pyramid.

It is vital for an investor to keep this in mind when creating a portfolio. In an investment risk pyramid, a portfolio is presented as a pyramid delving into the various levels of different investment types. The investment risk pyramid has three separate tiers

Base level

Middle level

Top-level

Base level

As the start of the pyramid, it is the foundation of the risk. This represents investments that possess the lowest levels of risk like

Cash and equivalents of cash

Treasury bonds

Government bonds

Certificates of deposits and other instruments

Here, the chances of an investor suffering an investment loss is low as the risk levels are low. However, the return on investments is also low.

Middle level

Representing the middle of the pyramid, they depict a moderate level of risk. Compared to the base level, the middle level is not that safe, but when compared to the top level, it is still safer and is perfect for an investor like Jack. The types of investments in levels are

Real estate

Dividend stocks

Indices

Stocks

Investment Grade Corporate Bonds

Investments here are stable, bring in returns and ensure a possibility of capital appreciation.

Top-level

The last level of the pyramid, the top-level, represents investment options with the highest levels of risk. It includes assets like

Penny stocks

Futures

Commodities

Options and others

For the high level of risk associated with this level, they also provide high returns on investments. There is a huge earning potential for these investments, and they are capable of good returns. Plus, compared to the other two levels, the investment capital is also higher.

This would be ideal for Jack if he began investing at an early age. After all, any investor considering top-level investments must be ready mentally to lose money, which is possible for a young investor who still has the opportunity to make money.

Should investors follow the risk pyramid?

In the investment risk pyramid, asset allocation is based on risk management. So, the higher the risk, the higher the returns. Thus, it depends on an investor’s profile and risk capacity. It was observed that

40% to 50% will invest in base level instruments

30% to 40% will invest in middle-level instruments

10% to 30% will invest in top-level assets

The strategy is good, but it doesn’t always get it right. This is because the investment risk pyramid keeps changing and is customized to the investor.

As an investor’s income earning capacity is different, so are its risk appetites. Once an investor determines their risk-bearing ability, they can access their financial position. They will be able to understand how much they are willing to invest and how much they are willing to lose. Thus, preparing them for future investments.