Determining Risk and Understanding the Risk Pyramid

When you begin investing, there are a few key checks to run. The first is to define your financial goals clearly. Without knowing what you are investing in, it can be rather tricky to choose the right strategy.

The second step is to look at your time horizon. Are your goals short-term, medium-term, or long-term in nature? The timeline for when you will need the money plays a colossal role in deciding where to put it.

The third step, and the one we will be discussing here, is to assess your risk appetite. This is your ability and, to a great extent, willingness to take on risk, which will ultimately determine the types of investments best suited for you.

The key to understanding investment risk lies in the concept of the risk pyramid. The investment risk pyramid illustrates how different types of assets carry varying levels of risk and potential returns.

This article will walk you through how the investment pyramid works and how you can use it to build a portfolio that fits your goals. So, let’s get started.

Understanding investment risk and reward

Understanding investment risk and reward is one of the most crucial aspects of being a savvy investor. Too often, people jump into investments with the hope of making quick money. They pursue speculative bets without truly considering what they stand to lose if things do not go as planned. Risk is at the core of every investment decision, and until you understand how it works, you may never really feel in control of your money.

So, let’s break it down.

You need to determine how much risk you can actually afford to take when investing your money. This has very little to do with any external stimuli and is solely about you, your capacity, and your preferences. Some people can handle the ups and downs in their investment portfolio without stress. However, others may find it nerve-racking and even traumatic when their investments drop even slightly.

There is no right or wrong answer here. It is simply about knowing yourself. Your level of risk tolerance is often directly tied to your financial goals and timeframe. For instance, if you are trying to grow your wealth over the long term, you might be comfortable with higher-risk investments, such as stocks. They can fluctuate significantly in the short term, but historically, they have offered higher returns over the long term.

On the other hand, if your primary concern is to protect and preserve your money for the years ahead, then safer options such as bonds, Certificates of Deposit (CDs), or savings accounts may be more suitable.

The single most important principle to remember here is that risk and reward are connected. It is a common saying in finance that the higher the risk, the higher the potential reward. But notice the word “potential.” High risk does not guarantee high returns. It only opens the door for them. Take the stock market, for example. Over time, it has rewarded investors with strong returns, but it has also experienced periods of decline, during which people have incurred losses.

Low-risk investments usually offer lower returns. For instance, take the example of the money in your savings account. It is safe. You won’t lose it. But the return is so small that it barely keeps up with inflation, if at all. So, you essentially bargain off the possibility of higher growth for peace of mind and stability.

Ultimately, what this comes down to is balance. Your investment choices should reflect both your appetite for risk and the goals you are working toward. Some people will thrive with a mix of safe and risky assets, while others will stick to one side of the pyramid. The important thing is that you make decisions based on understanding, not impulse or peer pressure.

Now, speaking of the pyramid, let’s move to understanding the investment risk pyramid, what it means, and how it works.

What is the investment risk pyramid?

Have you ever seen the Pyramids of Giza? Perhaps you have been fortunate enough to see them in person, or perhaps you have only admired them in photographs. Either way, chances are you know exactly what they look like.

The structure is simple but powerful. The base of the pyramid is broad and wide and provides stability to the entire monument. Without that strong foundation, the pyramid would not be able to stand tall for thousands of years. As your eyes move upward, the shape gradually narrows.

At the very top sits the smallest, sharpest point. It might be the narrowest part of the structure, but it also gives the most remarkable perspective. Historians even believe that, in ancient times, standing at the top would have offered breathtaking views not just of Giza itself, but also of Cairo and the flowing Nile River in the distance.

When considering an investment, it helps to visualize a pyramid.

The investment risk pyramid is a similar structure. Here’s how it is designed:

1. Top tier, also known as the summit

Let’s start at the top, which is the smallest and narrowest part of the structure. This is where the high-risk investments live. It is the tip. In your portfolio, this tier can also take up the least space, especially if you are a conservative investor.

The top tier comprises assets such as individual stocks, futures, options, commodities and even collectibles. These investments offer the potential for high returns, but they also carry the risk of losses. You should only put money here that you can afford to lose without throwing your entire financial plan off track.

The reason it is advised to do so is that in a scenario where the market turns against you, you would not be in a position where selling at a loss ruins your goals. At the same time, if luck and timing are on your side, this is the part of the pyramid that can give your portfolio that extra boost. It certainly is a growth-oriented component of the pyramid, but it demands caution.

2. Middle tier

Moving down one level, you will reach the middle portion of the pyramid. Which investment option is in the mid segment of the risk pyramid? This is where you will find medium-risk investments, such as high-income bonds, large/small cap stocks, or certain types of real estate. These investments do carry some volatility and are not without risk, especially in the short term.

However, they are significantly more stable than the top of the pyramid, especially in the mid-to-long term. They can also appreciate in value, as in the case of real estate and can give you both income and growth potential. The middle layer is where the real balance lies. It is neither too conservative nor too aggressive.

3. Base tier

Finally, let’s get to the base of the investment pyramid. This layer consists of low-risk investments, including savings accounts, CDs, government bonds, treasury bills, and money market funds. These are not the types of assets that will generate exponential returns. In fact, their returns are usually modest, and sometimes they may not even keep pace with inflation.

But what they do offer is stability. The money you invest here is safe and easily accessible if you need it. This portion of your investment portfolio is especially important if you are risk-averse. These investments are often used by retirees or those nearing retirement. For younger investors, the base might take up a smaller share since they have time to ride out the ups and downs of riskier assets.

Benefits of using the investment risk pyramid

• It provides a straightforward approach to understanding a complex investing world that encompasses multiple assets, risk profiles, and functions.
• It streamlines the process by categorizing assets into low, medium, and high-risk buckets, allowing you to quickly understand the risk profile of your investments.
• It offers clarity and eliminates confusion.
• It doubles as an educational tool, teaching you how different assets behave and why they belong in certain categories.

How do you use the investment pyramid?

Apart from risk, another key element in investing is personalization. There is no universal cookie-cutter formula that works for everyone. Your financial plan should reflect your unique goals, timeline, and comfort level with risk. The same applies to the investment pyramid. It is a useful guideline cum framework, but it is not meant to be followed thoughtlessly.

The risk pyramid suggests that a larger share of your money should be allocated to safer investments at the base, with smaller portions invested in riskier assets toward the top. However, in practice, your version of the investment pyramid may look quite different, depending on your stage of life and priorities.

Suppose you are in your early 30s. At this age, you may not be thinking of retirement anytime soon. It could be years, in fact, decades before you retire. Considering these aspects, you may allocate more of your money toward the upper part of the pyramid, which includes stocks, equity funds, and other investments, since you have time to weather market swings and benefit from long-term growth. Investing too much of your money in safe but low-yielding assets, such as CDs, at this stage could hinder your progress and limit your ability to keep pace with inflation.

But if you are in your 50s and approaching retirement, your pyramid would look different. At this point, preserving your capital may be your top concern. You may choose to allocate more of your money to the middle tier, such as high-income bonds, index funds, or stocks. You may also want to strengthen your base with safer investments, such as CDs or money market accounts. The top tier would naturally shrink at this age because a large exposure to risky assets this late could jeopardize your financial security if markets take a downturn.

It is essential to note that the investment risk pyramid is quite flexible. The nature of each tier remains unchanged. The top will always be volatile, the middle will be more balanced, and the base will be more stable. What changes is how much weight you give to each layer based on your personal circumstances. You can decide the allocation of your assets based on how you want your investment portfolio to look and work.

Working through the investment risk pyramid can seem tricky. How do you select the exact allocations based on your requirements? Well, you can do this by working with a financial advisor. Financial advisors are professionals who can help you evaluate your financial goals, risk appetite, and investment horizon. They can recommend suitable investments based on these factors and help you create a personalized investment pyramid strategy that aligns with your financial needs.

Building a Pyramid That Fits You

An investment risk pyramid serves as a guideline to help you make informed financial decisions. It helps you categorize your investments into low, medium, and high-risk levels, so you don’t feel overwhelmed or confused about where your money should be allocated. It can bring clarity and structure to the investing process. However, the real value lies in understanding how each layer of the pyramid works and then adjusting it to fit your own life stage and level of comfort with risk. There is no “one size fits all” strategy that works here.

If you ever feel unsure, consulting a financial advisor can be helpful. They can help you understand your investment options and guide you on how to build a personalized risk pyramid. Tools like the Wiser Advisor’s free advisor match tool can even connect you with an advisor nearby, making the process easier.

For additional information on retirement planning strategies tailored to your specific financial needs and goals, please visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm that manages private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services tailored to each client’s unique needs, providing institutional-caliber money management services based on a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.