Investors for a long time have used the risk pyramid to construct their portfolio of investments. This would help them in creating wealth and build their income. Here in this article, we would take a look at the risk pyramid and how to use this tool to create and diversify your portfolio.
The risk pyramid is also known as the investment pyramid and the risk pyramid is essentially a way for investors to construct an investment portfolio. It provides them a facility to pick investments and work accordingly to the risk levels of types of assets.
The portfolio is presented in the form of a pyramid and the concepts will deal with risk levels of different types of investments. The investors have named the strategy a risk pyramid.
The risk pyramid has three separate tiers: the base level, middle and top level. The pyramid represents the risk at different levels of the structure. Let us examine the three levels of the pyramid beginning from the base.
- Base level
- Middle level
- Top-level
1. Base level
The base level is the beginning of the pyramid and it is called the foundation of the risk. This will represent the investment options that will possess the lowest level of risk. The aspects involved as cash and cash equivalents, government bonds, T- bills, bonds, certificates of deposits, and other instruments.
The chance of suffering a risk is very low at this level. The risk level is low and the probability of suffering a default risk is also very low. Investments in these levels are the safest investments for investors. The rate of return on these investments is also very low in these types of investments. The base of the pyramid is wider; at this level, the risk of investment is lower for these low-risk investment options.
2. Middle level
This level represents the investment options that are in the middle level of the pyramid. There is a moderate level of risk in this level of investment. It is not as safe as compared to the lower level of pyramid investments. The investments made at this level are still safe compared to the top level.
The types of investments in this middle level of the investment pyramid are real estate investments, dividend stocks, index funds, growth stocks and others form part of the middle portion of the pyramid.
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3. Top-level
Top-level is the last level in the pyramid and this represents the investment options that will carry a high level of risk. This will include the asset classes like penny stocks, futures, commodities, options, and others.
There are the highest rewards associated with this level of investment. They provide high returns on the investments. These kinds of investments have huge earning potential and they are capable of good returns. The investment capital is also higher when compared to the other levels of investments.
In the top level of the investments, the risk is usually higher and the space occupied in the pyramid is very small. In this type of investment when you are investing you should consider and be ready for losing the money which you afford to lose. When you are making the investment you should be ready to lose that amount of money.
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Should investors follow the risk pyramid?
The asset allocation in the risk pyramid is based on risk management. The higher the risk the higher the returns. Investors based on their profile category and capacity will invest in the investments. It is observed that 40 to 50 percent of investors will invest in the low-risk category, 30 to 40 percent of people will invest in the moderate risk and 10 to 30 percent of the investors will invest in the high-risk assets.
This is a good strategy and it may not always be right at all times. It may keep changing from time to time and the risk pyramid is customized based on the financial position, appetite, and other factors. All the investors are not the same and different investors will have different strategies, different levels of income, different risk-bearing capacities, and other factors.
The financial position of the investors is a very important factor that will determine the risk-bearing capacity of investors. Since income earning capacity is different, and risk bearing levels are different, the investors will invest differently into the three levels of the pyramid.
Determining the risk-bearing capacity is very important and the investors should first determine the risk-taking ability. After doing this, you should be able to access the financial position. It will give you a fair understanding of what amount you can afford to invest and are ready to lose. This will help the investor to prepare for future investments.
Take away
A risk Pyramid is a tool for investors to prepare their investment portfolio. It will allow the investors to pick the right investments for the portfolio according to their risk levels of assets. Low-income investors can invest in the lower level of the pyramid, moderate-income investors can invest in the middle level and higher income can invest in top-level securities. Since the loss-bearing capacity is different and divided into three categories based on this factor an investor can make the investment decisions.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.
