You might be familiar with the concept of risk-reward, which states that the higher the risk of a particular investment, the higher the possible return. But many individual investors do not understand how to determine the appropriate risk level their portfolios should bear.
This article provides a general framework that any investor can use to assess the personal level of risk and how this level relates to different potential investments.
- The investment risk pyramid is an asset allocation strategy whereby low-risk assets like cash and treasuries are placed at the bottom, and smaller allocations to riskier assets like growth stocks are placed at the top.
- The middle of the pyramid represents moderately-risky assets like corporate bonds and blue-chip stocks.
- The resulting pyramid structure should balance risk and reward based on an individual's time horizon, assets, and risk tolerance.
Explaining the Investment Risk Pyramid
Risk-reward is a general trade-off underlying nearly anything from which a return can be generated. Anytime you invest money into something, there is a risk, whether large or small, that you might not get your money back—that the investment may fail. For bearing that risk, you expect a return that compensates you for potential losses. In theory, the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive, on average.
In the chart below, we see the range of risk levels that apply to different types of investment securities. These categories, ranging from conservative to very aggressive, correspond with the potential returns you could earn on an investment. Conservative investments offer you lower risk and moderate profits, while very aggressive investments provide a chance for outsized gains but also expose you to the possibility of big losses.
Determining Your Risk Tolerance
When deciding on an investment strategy, one of the key factors to consider is your risk tolerance, or how much risk you are willing to accept with your investment. Meanwhile, your risk capacity is the amount of financial risk that you are able to take on given your current financial situation. Whereas your risk tolerance has to do with your comfort level in taking on risk under current conditions, your risk capacity depends on how much you can afford to invest and the returns that you will need to generate to meet your goals.
With so many different types of investments to choose from, how does an investor determine how much risk they should take? Every individual is different, and it's hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take:
- Time Horizon: Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have $20,000 to invest today but need it in one year for a down payment on a new house, investing the money in higher-risk stocks is not the best strategy. The riskier an investment is, the greater its volatility or price fluctuations. So if your time horizon is relatively short, you may be forced to sell your securities at a significant loss. With a longer time horizon, investors have more time to recoup any possible losses and are therefore theoretically more tolerant of higher risks. For example, if that $20,000 is meant for a lakeside cottage that you are planning to buy in 10 years, you can invest the money into higher-risk stocks. Why? Because there is more time available to recover any losses and less likelihood of being forced to sell out of the position too early.
- Bankroll: Determining the amount of money you can stand to lose is another important factor in figuring out your risk tolerance. This might not be the most optimistic method of investing; however, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you won't be pressured to sell off any investments because of panic or liquidity issues. The more money you have, the more risk you are able to take. Compare, for instance, a person who has a net worth of $50,000 to another person who has a net worth of $5 million. If both invest $25,000 of their net worth into securities, the person with the lower net worth will be more affected by a decline than the person with the higher net worth.
Investment Risk Pyramid
After deciding how much risk is acceptable in your portfolio by acknowledging your time horizon and bankroll, you can use the investment pyramid approach for balancing your assets. Although this chart is by no means scientific, it provides a guideline that investors can use when picking different investments.
The pyramid is an asset allocation tool that investors can use to diversify their portfolio according to the risk profile of each security. Located on the upper portion of this chart are investments that have higher risks but might offer investors a higher potential for above-average returns. On the lower portion are much safer investments, but these investments have a lower potential for high returns.
The pyramid, representing the investor's portfolio, has three distinct tiers:
- The Base of the Pyramid: The foundation of the pyramid represents the strongest portion, which supports everything above it. This area should consist of investments that are low in risk and have foreseeable returns. It is the largest area and comprises the bulk of your assets.
- Middle Portion: This area should be made up of medium-risk investments that offer a stable return while still allowing for capital appreciation. Although riskier than the assets creating the base, these investments should still be relatively safe.
- Summit: Reserved specifically for high-risk investments, this is the smallest area of the pyramid (portfolio) and should consist of money you can lose without any serious repercussions. Furthermore, money in the summit should be fairly disposable so you don't have to sell prematurely in instances where there are capital losses.
Why Are Stocks Considered to Be Riskier than Bonds?
On average, stocks have higher price volatility than bonds. This is because bonds afford certain protections and guarantees that stocks do not. For instance, creditors have greater bankruptcy protection than equity shareholders. Bonds also provide steady promises of interest payments and the return of principal even if the company is not profitable. Stocks, on the other hand, provide no such guarantees.
What Is the Risk-Return Tradeoff?
In general, investors need to be compensated for additional risk in the form of greater expected returns. In relation to stocks being riskier than bonds, the former also has a higher expected return, known as the equity risk premium. Note, however, that this only applies to investments. Note that a casino game, in contrast to an investment, has a negative expected return. As a result, a gambler who takes on greater risk actually increases their expected losses over time.
What Is the Safest Investment?
Generally, government bonds issued by developed economies are considered the safest investments. In fact, they are sometimes referred to as risk-free, since a government has the option (in theory) of printing more money in order to cover its debts. U.S. Treasuries are therefore among the safest investments around (but often provide the lowest returns because of this fact).
The Bottom Line
Not all investors are created equal. While some prefer less risk, other investors prefer even more risk than those who have a larger net worth. This diversity leads to the beauty of the investment pyramid. Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base. The pyramid representing your portfolio should be customized to your risk preference.
It is important for investors to understand the idea of risk and how it applies to them. Making informed investment decisions entails not only researching individual securities but also understanding your own finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are seeking.