What is the investment pyramid?

The investment pyramid provides a fast visual context about the types of investments that are known to carry more or less risk or associated rewards compared to other investments.

Definition and Example of the Investment Pyramid

The investment pyramid is a tiered structure that helps investors understand the overall risk and reward level of a particular investment. Although the investment pyramid cannot accurately predict investment performance, it can assist investors in identifying the types of investments that may be suitable for their specific risk tolerance.

Alternative name: Investment Risk Pyramid

For example, the first layer of the pyramid includes savings accounts. As a first-tier investment, savings accounts may be suitable if you want to avoid risk, as they provide a way for you to earn interest on your savings with almost no risk. However, the reward level for a savings account is low. Investors seeking better returns may want to consider stocks, which, although they carry greater risks, have the potential for higher rewards.

The investment pyramid can help investors consider these risk and reward factors to formulate an investment plan that they feel comfortable with.

How Does the Investment Pyramid Work?

The investment pyramid consists of a series of layers, with the broader lower layers carrying less risk and the smaller upper layers carrying more risk. The number of layers in the investment pyramid depends on the broker or financial institution preparing the pyramid. Below is an example of a five-tier investment pyramid:

First Layer

The bottom layer of the investment pyramid represents investments that carry the least risk and the lowest rate of return. These investments are considered “safe” and include:

• U.S. government securities: Including savings bonds, treasury bonds, treasury bills, and bonds.
• Securities issued by government agencies: Debt securities issued by Ginnie Mae, Freddie Mac, and Fannie Mae, which are bought and sold in financial markets.
• Savings and checking accounts: Savings and checking accounts are completely safe as they are insured by the Federal Deposit Insurance Corporation (FDIC).
• Certificates of deposit (CDs): A certificate of deposit is an investment with a guaranteed outcome and a slightly higher interest rate than a savings account.

Money market funds and fixed businesses can also be considered first-tier or foundational investments. Since lower-tier investments offer low returns along with low risks, they are exposed to inflation risk.

Second Layer

The second layer consists of low-risk investments with stable yields, such as municipal bonds, corporate bonds, preferred stocks, and convertible securities. Investments in the second layer are relatively safe but share inflation risks with the lower layer.

Third Layer

The third layer contains relatively low-risk investments that provide a higher rate of return than the lower two layers. This layer includes blue-chip stocks, growth and balanced mutual funds, and variable annuities. Although they are considered relatively stable, these investments come with better rates of return than those found in the first and second layers.

Fourth Layer

In the fourth layer, you will find stocks and equity funds, including large, mid, and small-cap stocks. Small and mid-cap stocks carry more risk than large-cap stocks. Mutual funds also fall into this layer, which allow investors to invest their money in multiple companies at the same time by purchasing a single fund.

Fifth Layer

The top of the investment pyramid represents the most risky investments; options, futures, and speculative stocks and bonds are found here. While the rewards can be significant, the losses can also be substantial. For example, certain futures contracts can expose investors to unlimited loss risks.

Note:

Some investment pyramids use a three-tiered approach, dividing investments into three groups: low risk, medium risk, and high risk.

Advantages and Disadvantages of the Investment Pyramid

Advantages

• A good introduction to levels of risk in investing: The investment pyramid is a great way to quickly understand which types of investments are considered riskier than others.
• Provides clarity: If you’re struggling to decide how to invest your money, the investment pyramid can help you compare and contrast the options available to you.

Disadvantages

• You make the final investment decision and bear all the risks: The investment pyramid is more of an educational tool; you are the one who has to make the final decision on how to invest your money, and you will bear all the risks.
• Lacks detail: The investment pyramid can give you a general idea of what investments have historically been riskier and more likely to deliver substantial rewards, but it doesn’t take into account that all investments are unique.

What Does This Mean for Individual Investors?

New investors who are not ready to hire an investment advisor can use the investment pyramid to get an idea of what types of investments fit their comfort level with risk. However, you cannot make an informed decision about how to invest your money just by looking at the investment pyramid. You also need to do your own research on each investment option you are considering.

Here are some questions to ask yourself before choosing an investment avenue:

• What kind of return can you expect from this investment?
• What level of return do you want, and what is a typical return for this type of investment?
• What risks are you willing to take?
• Can you sell or convert the investment to cash in case of need, and what will it cost you to sell it?

Takeaway

The investment pyramid is a visual tool that provides context on the types of investments that carry more or less risk and the rewards associated with them. The investment pyramid has layers that range in risk and reward, with the bottom layer representing the safest investments with the least chance for rewards, while the top layer represents the most risky investments with the highest chance for rewards. New investors can use the investment pyramid to get a general idea of what types of investments fit their comfort level with risk, but they should also conduct their own research before making an investment decision.

Source: https://www.thebalancemoney.com/what-is-an-investment-pyramid-5223343