A risk pyramid, also known as an investment pyramid, is a strategy an investor uses to determine how to invest his money. This concept helps an investor decide how to allocate assets based on the perceived level of risk of the investments. The risk pyramid is important because it allows the investor to assess and adjust the risk of his portfolio.
The pyramid is made of three layers: the base, the middle and the summit. The base of the pyramid consists of low-risk assets, such as cash and cash equivalents, government bonds and certificates of deposit (CDs). This part of the pyramid should constitute the largest part of an investor’s portfolio. The middle portion consists of medium-risk investments, such as large-cap stocks, mutual funds, blue-chip stocks and real estate. The summit of the pyramid consists of high-risk assets, such as swaps, penny stocks and collectibles. An investor should allocate a small portion of his assets to this layer of the portfolio.
The risk pyramid is important for all investors regardless of their risk profiles. The principle behind the risk pyramid ensures investors are not overexposed to any one particular aspect of the market. Investors who prefer less risk can allocate more of their funds to safer securities, or the base, and those who prefer more risk can invest in riskier assets, or the summit.
For example, say a beginning investor is highly risk-averse. He may allocate 70% of his portfolio to the base of the pyramid, 20% to the middle portion and 10% to the summit. Without the use of a risk pyramid, the beginning investor may allocate his portfolio incorrectly, which could result in major losses.