The Investment Pyramid
The “Investment Pyramid” is typically drawn like a pyramid – hence the name – with all the most secure investments on the bottom and the most risky investments in the peak on the top. Once upon a time there were few really risky investments and loads of secure investments and the pyramid made some sense. Not so today. It can be pretty difficult squeezing all those new risky investment alternatives into that tiny pyramid-peak. I’m not sure why the pyramid remains part of the whole gestalt, except that perhaps it is meant to motivate investors to move-on-up! Let’s face it, isn’t the view from the top of a pyramid better? Hmmm.
Anyhoo, while pyramid image has been used forever, that’s about to change. Since a pyramid has the connotation that things on the top are better than things on the bottom, or that you should hold more of the things on the bottom than the things on the top, I’m foregoing the pyramid for a plain ol’ chart, where the investments are “stacked” from least risky to most risky.
- HIGHEST RISK: Futures, Stock Options, Precious Metals/Gems, Emerging Markets, Speculative Stocks & Bonds, Collectibles, Small-cap Stocks, Undeveloped Land, Puts & Calls
- HIGH RISK: Blue Chip Stocks, Quality Growth Mutual Funds, Income Properties, Large-cap Stocks, Royalty Trusts
- MEDIUM RISK: Balanced Mutual Funds, High-grade Preferred Shares, High-grade Convertible Securities
- LOW RISK: Strip Bonds, Bond Mutual Funds, Bankers’ Acceptances, Government Bonds, Corporate Bonds
- LOWEST RISK: Cash, Savings Accounts, GICs and Term Deposits, Money Market Funds, Treasury Bills
Risk comes in many forms. Volatility is the one most people are afraid of, and the one we tend to over-react to. When the value of an investment goes up and down a lot over a short or medium period of time, that investment is said to be volatile. Know you might expect things like speculative stocks to be volatile, but you might be surprised at where else volatility raises it's scary head. Industry-specific mutual funds, such as mining or technology, or funds that invest in small-capitalization companies can be very volatile. And even bonds can be volatile if interest rates start to jitterbug.
Lots of people have a fear of Capital Risk, which is the potential for losing some or all of the original money you invested (which is your "capital".) People with a huge fear of capital risk stick to tried-and-true investments like term deposits or GIC, only to then run smack-dab into Interest-rate Risk.
Geeze-Louise, what possible risk could there be with interest? I'm so glad you asked.
One risk is that interest rates will rise and you will be locked in to a lower rate. Another is that if you've invested at a high rate, interest rates may be a lot lower when it comes time to renew. Well, at least there's your risk-free savings account, right? Wrong again! If your interest rate is the same or lower than the current rate of inflation, you're facing a whole different kind of risk: Inflation Risk. The end result is that your money will be worth less.
Everyone measures risk differently. If you have $500,000 to invest, then sticking $5,000 in a stock may feel like an okay thing to do. But if that $5,000 represents all the money you've managed to squirrel away, the risk can seem life changing and you'll be less willing to throw caution to the wind.
So how do you reduce your exposure to risk? Good question. The key is to hedge your bets to protect yourself from swings in any one type of investment. To do that, you have to diversify.