Broker Check

Pyramid of Risk

May 07, 2024


Have you ever heard of the Pyramid of Risk? This strategic tool aids in categorizing investments, guiding us from high-risk and possibly high-return at the top of the pyramid to low-risk options at the bottom. Utilizing the pyramid can ensure an investment allocation that aligns with your unique volatility tolerance, needs, and goals.

 

We find high-risk investments, such as alternative investments, at the pinnacle of the pyramid. Commodities like oil or gold, collectibles like vintage cars and art, and real estate investment trusts (REITs) all fit into the category of alternative investments. Other high-risk investments more common in a portfolio are individual stocks and bonds. These are considered high-risk due to their lack of diversification, potential illiquidity, and susceptibility to significant market fluctuations. Remember the lessons from companies like Fannie Mae, Freddie Mac, and Enron—reminders that even seemingly invincible entities can face financial challenges.

 

Moving to the middle of the pyramid, we encounter medium-risk investments like stock funds, bond funds, ETFs (exchange-traded funds), indexed funds, and variable annuities. Variable annuities, if unfamiliar, can be explained as having mutual funds inside, subjecting your investment to market fluctuations. The same is true of variable life insurance, which includes a cash value component that can be invested in mutual funds.

 

Finally, at the pyramid's base, we find low-risk investments—fixed and indexed annuities, government bonds, fixed life insurance, cash, savings, CDs, and money market options. These low-risk options provide stability, avoiding direct exposure to market volatility. If the concept of fixed annuities is new – this is an annuity with a fixed interest rate associated with it; similarly, fixed life insurance has a fixed rate. An index annuity is an annuity whose interest rate is tied to an index – this could be the S&P 500 or another strategy. Typically, index annuities will put a cap or ceiling on your earnings potential, and there is a floor where the annuity cannot decline in value based on index performance.

 

As you look up from the pyramid's base to the peak, you will find volatility and potential return opportunities increasing. Volatility is the pricing fluctuation that we experience daily. Risk, on the other hand, encompasses the potential for permanent loss. The difference between the middle of the pyramid and the peak is diversification. Diversification is a strategy to reduce risk – as Grandma said, it's helpful not to keep those eggs all in the same basket. By spreading investments across different asset classes, sectors, and regions, you reduce the impact of poor performance on any single investment in your portfolio. Diversification creates a buffer against market volatility and unforeseen events, fostering stability and possibly enhancing long-term returns.

 

As we navigate your financial plan, it's vital to recognize that the strength of any plan lies in its foundation. In retirement, the foundation is predictable income. Understanding your volatility tolerance, needs, and goals is paramount for appropriate allocation.