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Guide to Investment Risk Pyramids

By Mike Zaccardi, CMT, CFA · October 10, 2022 · 6 minute read

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Guide to Investment Risk Pyramids

An investment risk pyramid is an illustration used to help investors understand the risk/reward profile of various assets. The investing risk pyramid uses a base, middle, and top to rank investments by the likelihood of losing money or seeing big gains. The tool is useful when getting started with investing.

Building a portfolio is no easy task. It requires due diligence and an assessment of your risk tolerance and return goals. The investment risk pyramid helps you determine what approaches work best for you.

What Are Investment Pyramids?

Investment pyramids are practical tools for gauging how risky certain asset types are. The pyramid model has been used in many areas for a long time, and it’s useful when learning what your risk tolerance is.

The investing risk pyramid has three levels grouped by risk/return profile. The safest securities are found in the large base; growth and moderately risky assets are in the middle; then the most speculative strategies are at the top.

How Investing Pyramids Work

There are many investing risk need-to-knows, and the pyramid of investment risk works by helping investors understand the connection between their asset allocation and their risk tolerance.

The visual should ultimately lead individuals to better grasp what percentage of their investable assets should go to which types of investments based on risk level and return potential.

Using a risk pyramid investment strategy provides a basic framework for analyzing portfolio construction. The investment risk pyramid is structured so that it suggests people hold a higher percentage of safer assets, and relatively little in the way of ultra-high-risk speculative assets.

Base of the Pyramid

Managing investment risk is among the most fundamental aspects of investing, and risk is controlled by ensuring an allocation to some safe securities. The base of the investment risk pyramid, which is the bulk of total assets, contains low-risk assets and accounts. Investments such as government bonds, money markets, savings and checking accounts, certificates of deposit (CDs), and cash are included in the base.

While these securities feature relatively minor risk, you might lose out to inflation over time if you hold too much cash, for example.

Middle of the Pyramid

Let’s step up our risk game a bit by venturing into the middle of the investing risk pyramid. Here we will find medium-risk assets. In general, investments with some growth potential and a lower risk profile are in this tier. Growth and income stocks and capital appreciation funds are examples.

Other holdings might include real estate, dividend stock mutual funds, and even some higher-risk bond funds.

Top of the Pyramid

At the top of the investment risk pyramid is where you’ll find the most speculative asset types and even margin investing strategies. Options, futures, and collectibles are examples of high-risk investments.

You will notice that the top of the pyramid of investment risk is the smallest – which suggests only a small portion of your portfolio should go to this high-risk, high-reward niche.

Sample Investment Pyramid

Here’s what a sample investment risk pyramid might contain:

Top of the pyramid, high risk: Speculative growth stocks, put and call options, commodities, collectibles, cryptocurrency, and non-fungible tokens (NFTs). Just a small amount should be allocated to the top of the pyramid.

Middle of the pyramid, moderate risk: Dividend mutual funds, corporate bond funds, blue-chip stocks, and variable annuities. Small-cap stocks and foreign funds can be included, too. A 30-40% allocation could make sense.

Base of the pyramid, low risk: U.S. government Treasuries, checking and savings accounts, CDs, AAA-rated corporate bonds. This might be 40-50% of the portfolio.

Pros and Cons of Investment Pyramids

The investment risk pyramid has advantages and disadvantages. Let’s outline those to help determine the right investing strategy for you.

Pros

The investing risk pyramid is useful as a quick introduction to asset allocation and bucketing. Another upside is that it is a direct way to differentiate asset types by risk.

Cons

While the investing risk pyramid is helpful for beginners, as you build wealth, you might need more elaborate strategies beyond the pyramid’s simplicity. Moreover, in the end, you determine what securities to own – the pyramid is just a suggestion.

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Examples of Low-Risk Investments

Let’s describe some low-risk investments in more detail since these are including the investment risk pyramid’s biggest tier.

Bonds

Bonds are essentially a loan you make to the government or other entity for a set amount of time. In return for lending your money, the debtor promises to pay you back at maturity along with periodic coupon payments, like interest.

Safer bonds include short-term Treasury bills while riskier bonds are issued by speculative companies at a higher yield.

Cash

Cash feels like a safe asset, but ideally you would store it in an interest-bearing savings account in order to keep up with inflation.

Also consider that holding too much cash can expose you to inflation risk, which is when cash loses value relative to the cost of living.

Bank Accounts

You can earn a rate of return through a SoFi bank account with FDIC insurance. Keeping an emergency fund in a checking account can be a prudent move so you can pay expenses without having to sell assets like stocks and bonds or take on debt.

Examples of High-Risk Investments

Let’s jump up top to the high-risk part of the investment risk pyramid. Here you will find assets and strategies that can earn big profits, but also expose you to serious losses. Margin trading is a method employed with some of these securities.

Margin Trading

Margin trading is using borrowed funds in an attempt to amplify returns. A cash account vs. margin account has key differences to consider before you go about trading. Trading with leverage offers investors the possibility of large short-term gains as well as the potential for outsize losses, so it perhaps best suited for sophisticated investors.

Options

Options on stocks and exchange-traded funds (ETFs) are popular these days. Options, through calls and puts, are derivative instruments that offer holders the right but not the obligation to buy shares at a specific price at a pre-determined time. These are risky since you can lose your entire premium if the option contract strategy does not work out for the holder. Compound options are an ultra-risky option type. The reward potential is massive since options can go up thousands of percent if certain market conditions happen.

Collectibles

Collectibles and artwork are alternative investment types that may provide some of the benefits of diversification, but it’s hard to know what various items are worth since they are not valued frequently. Consider that stocks and many bonds are priced at least daily.

Collectibles might also go through fad periods and booms and bust cycles, which can add to the risk factors in this category.

Discovering Your Risk Tolerance

The investment risk pyramid is all about helping you figure out your ability and willingness to accept risk. It is a fundamental piece of being an investor. You should consider doing more research and even speaking with a financial advisor for a more detailed risk assessment along with an analysis of what your long-term financial goals are.

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Using an investment risk pyramid can make sense for many investors. It’s an easy, visual way to decide which asset classes you might want to hold in your portfolio, so that the percentage of each (i.e. your asset allocation) is aligned with your risk tolerance.

The other helpful aspect of the investment risk pyramid is that it presumes a bigger foundation in lower-risk investments (the bottom tier), with gradually smaller allocations to moderate risk and higher-risk assets, as you move up the pyramid. This can be helpful for a long-term strategy. In a nutshell, the investment risk pyramid helps you figure out how to allocate investments based on your risk tolerance and return objectives.

If you’re all set in terms of low- and moderate-risk investments, it could be time to explore how higher-risk, higher-return investments fit into your plan. Margin investing is a strategy that uses leverage to enable you to buy more of the investments you think have big growth potential. You can open a margin account with SoFi Invest and use it to buy stocks, exchange-traded funds (ETFs), IPO shares, fractional shares, crypto, and more. Round out your portfolio today!

FAQ

What are the levels of an investment pyramid?

The levels of an investment risk pyramid are low-risk at the base, moderate-risk in the middle, and high-risk at the top. The risk/return investment pyramid helps investors understand how to think about various assets they may want to own.

What does investment risk refer to?

Investment risk can be thought of as the variance in return, or how great the chance is that an investment will experience sharp losses. While the risk investment pyramid helps you build a portfolio, you should also recognize that a diversified stock portfolio performs well over time, while cash generally loses out due to the risk of inflation.

What are some examples of high-risk investments?

High-risk investments include speculative assets like options, trading securities on margin, and even some collectibles that might be hard to accurately value since they are based on what someone might be willing to pay for them. The low-risk to high-risk investments pyramid can include virtually any asset.


Photo credit: iStock/MicroStockHub

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