What is an Investment Pyramid
An investment pyramid, or risk pyramid, is a portfolio strategy that allocates assets according to the relative risk levels of those investments. The risk of an investment is defined in this strategy by the variance of the investment return, or the likelihood the investment will decrease in value to a large degree.
The bottom and widest part of the pyramid is comprised of low-risk investments, the mid-portion is composed of growth investments, and the smallest part at the top is allocated to speculative investments.
Key Takeaways
- The investment pyramid is an asset allocation strategy that investors use to diversify their portfolio investments according to the risk profile of each security.
- The pyramid, representing the investor's portfolio, has three distinct tiers: low-risk assets at the bottom such as cash and money markets; moderately risky assets like stocks and bonds in the middle; and high-risk speculative assets like derivatives at the top.
- The strategy calls for allocating the largest proportion of capital to the low-risk assets at the bottom, and the smallest amount to the speculative assets at the top.
Understanding the Investment Pyramid
An investment pyramid strategy builds a portfolio with the lowest risk investments as the base, equity securities of established companies as the middle, and speculative securities as the top.
- The base (i.e. the widest part of the pyramid) would contain the highest allocation of assets and would include cash and CDs, short-term government bonds, and money market securities.
- The middle part of the pyramid would include a moderate allocation to corporate bonds, stocks, and real estate. These assets are somewhat risky and have some probability of losing value, although over time they have positive expected returns.
- The top would include the smallest allocation weights and include highly risky, speculative investments that have a high chance of loss, but may also produce above-average returns. These would include derivatives contracts like options and futures (not used for hedging purposes), alternative investments, and collectibles such as artwork.
Within each risk layer of the pyramid, you see an increase in risk taking, but with a smaller allocation of overall funds available to invest. As a result, the higher you go up the pyramid, the greater the risk, but also greater the potential return.
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Note that not all investors have the same willingness and/or ability to take on risk. The pyramid representing a portfolio should be customized to an individual's particular risk preference and financial situation.
Example of an Investment Pyramid
As an example, Harold went to his financial advisor for advice on how to position his portfolio. The advisor suggested that based on Harold's goals, risk toleranceand time horizon, he should adopt an investment pyramid strategy. The advisor suggests that Harold put 40-50% of his portfolio in Treasury bonds and money market securities, 30-40% in mutual funds that invest in corporate stocks and bonds, and the rest in speculative items such as futures and commodities.
