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Climbing the Investment Risk Pyramid

It may be trite, but it's true: When it comes to making investments, risk and reward go hand-in-hand. You generally cannot have one without the other. That begs the question: How much risk are you willing to take for the potential reward? One way to analyze your risk tolerance is to build an investment plan around the traditional “risk pyramid.”

Background: Start by determining your main investment objectives. Do you wish to supplement your retirement income? Perhaps you want to set aside funds for a child's college education or wedding. Or maybe you have decided to launch a new business venture. Of course, you also need to consider such factors as your age, income, current expenses and family responsibilities.

Once you have set your future goals, you can examine your investment options. This is where the risk pyramid can come into play.

The lower-risk investments are on the bottom of the pyramid. As you work your way to the top, the risk increases. Although you will see different variations of the pyramid, here is a standard classification.

Bottom level: The foundation includes traditional “safe” investments such as government bonds, money market accounts, bank certificates of deposit (CDs), Treasury notes and bills, cash and cash equivalents.

Middle level: The medium investments pertaining to the risk pyramid are equity mutual funds, large- and small-cap stocks, high-income bonds and real estate.

Top level: At the very top rung, you will find higher-risk investments such as collectibles, futures and other sophisticated offerings.

Note: The top of the pyramid is not for the faint of heart. While these investments often provide the opportunity for rewards, they usually also contain the greatest risk.

Once you have examined the options and established the risk level for different types of investments, you can then make your choices. Consider the following three basic concepts as part of your final determination:

1. Even financially secure investors with a high-risk tolerance should have a few safe investments to fall back on. In other words, be careful not to risk more than you can afford.

2. Do not put all your investment eggs in one basket. As a general rule, it is recommended that you seek diversification within your portfolio. Diversification may help protect your investment from loss of principal—possibly resulting from a downturn in the stock market—and the loss of buying power stemming from a rise in inflation. Of course, there are no absolute guarantees.

3. Consider the liquidity of your investments. Depending on your particular financial situation, it may be important for you to be able to get in and out of investments quickly. That may necessitate some changes in your portfolio.

In any event, you must be comfortable with the investment choices you make. Also, consider all the tax aspects of your investments. Do not hesitate to seek professional assistance in this area.

 

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