Investment Risk Pyramid

4.3

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We’ve covered the different types of risk, the relationship between risk and volatility, alpha and beta, equity risk premium, and the CAPM model. Now that we’re done with all the heavy lifting, it's time for us to take a look at something that can help investors like you create the perfect portfolio - one that’s in line with your goals. And that something is ‘the risk pyramid’.

For a long time, scores of investors have successfully used the risk pyramid to construct their own portfolio of investment assets to help create wealth. In this chapter of Smart Money, we’re going to be taking a good look at the risk pyramid and how you can use it to create and diversify your investment portfolio.

The risk pyramid

Also known as an investment pyramid, the risk pyramid is essentially a strategy that investors use to construct an investment portfolio. It allows them to pick investments for their portfolio according to the risk levels of different assets.

The portfolio strategy is depicted in the form of a pyramid, with a wide base that decreases in size as you go up, and ultimately culminates in a pointed summit. Since this depiction resembles the shape of a pyramid, and since the concept deals with the risk levels of various investment assets, investors have aptly named the strategy as ‘the risk pyramid.’

Finding it hard to visualize? Here’s a pictorial representation of the risk pyramid.

As you can see from the figure above, the risk pyramid has three separate tiers - the base, the middle, and the top. The pyramid is even colour-coded here, which represents the relative risk levels of the different tiers of the structure. Let’s take a closer look at the three parts of the pyramid, starting with the base.

1. The base

The base is the foundation of the risk pyramid and represents investment options that possess the lowest amount of risk. This includes cash and cash equivalents, treasury bills, government securities, certificate of deposits, bonds, and other money market instruments.

The chances of these investments suffering from default risk - or any other risk for that matter - are very low. And so, these investment options are considered to be the safest among the lot. However, due to the low amount of risk involved, the rate of return on these investments also tends to be quite low.

Since the base of the pyramid is the widest, the strategy essentially advocates for a large amount of your portfolio consisting of these low-risk investment options. 

2. The middle

The middle part of the risk pyramid represents investment options that carry moderate levels of risk. Although not as safe as the risk pyramid investments that are at the base, the assets that make up the middle portion of the pyramid are still considered to be relatively safe. Investments like real estate, index funds, growth stocks, and dividend stocks, among others typically make up the middle portion of the pyramid.

The investment options under this tier usually offer consistent returns and good long-term capital appreciation. And since this tier of the pyramid is smaller than the base, but larger than the top, the strategy basically advocates for a moderate amount of portfolio allocation for these assets.

3. The top

Lastly, we have the top of the pyramid. This part represents investment options that carry the highest amount of risk. It includes asset classes like futures, options, commodities, and penny stocks, among others.

One of the key characteristics of these asset classes is that they’re capable of offering extremely high rewards. However, the reward comes at the cost of high risk. With these kinds of instruments, the chances of an investor losing a huge part of their investment capital are high.

This is precisely why the top tier of the risk pyramid is the smallest among the three. The strategy essentially advocates for the least amount of portfolio allocation towards these investment instruments. It also states that you should invest only that much amount of money that you consider disposable - or, in other words, money that you are okay with losing.

As an investor, should you always stick to the risk pyramid?

The risk pyramid asset allocation strategy states that investors should ideally invest a significant portion of their capital in low-risk instruments, a moderate portion of their capital in moderate-risk investments, and the least amount of capital in high-risk assets. This translates to around 40-50% in low-risk, 30-40% in moderate risk, and 10-30% in high-risk assets. While this is a really good strategy that works, it may not always be the right one.

This is primarily because the risk appetite and financial situation are not always the same across all investors. While some might be more averse to taking on risk, others might be more willing to invest a larger portion of their capital in high-risk investments. And so, the risk pyramid can and should be customized according to your risk profile, appetite, and financial position.

Therefore, before you go ahead and adopt the risk pyramid strategy of portfolio asset allocation, it is crucial to first determine your risk-taking potential. Once you’ve done that, you would also have to assess your financial position. This will give you a fair idea of the amount of disposable income that you have and can afford to lose. And finally, you would also need to chart out your short-term, mid-term, and long-term goals as well. Only when you’ve done all of this should you use the risk pyramid strategy to allocate assets to your portfolio.

Wrapping up

So, we’re done with yet another chapter of this module. In the next one, we’re going to be taking a look at why you should learn to say ‘yes’ to risk. Eager to find out more? Head to the next chapter then!

A quick recap

  • Also known as an investment pyramid, the risk pyramid is essentially a strategy that investors use to construct an investment portfolio. 
  • It allows them to pick investments for their portfolio according to the risk levels of different assets. 
  • The risk pyramid has three separate tiers - the base, the middle, and the top. 
  • The base is the foundation of the risk pyramid and represents investment options that possess the lowest amount of risk. 
  • The chances of these investments suffering from default risk - or any other risk for that matter - are very low. 
  • The middle part of the risk pyramid represents investment options that carry moderate levels of risk. 
  • The investment options under this tier usually offer consistent returns and good long-term capital appreciation. 
  • The top represents investment options that carry the highest amount of risk. 
  • The risk pyramid asset allocation strategy states that investors should ideally invest a significant portion of their capital in low-risk instruments, a moderate portion of their capital in moderate-risk investments, and the least amount of capital in high-risk assets. 
  • But before you go ahead and adopt the risk pyramid strategy of portfolio asset allocation, it is crucial to first determine your risk-taking potential.
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