HOW TO MAKE INVESTMENTS USING A RISK PYRAMID?

A risk pyramid (also called an investment pyramid) is a great tool for determining how you should invest your money. The concept is simple: a risk pyramid allows you to allocate assets based on their perceived level of risk, and thus helps you determine the overall risk level associated with your portfolio. By following a few simple steps, you can learn how to make investments using a risk pyramid.

Steps

Familiarize yourself with the concept of a risk pyramid. Imagine a pyramid that is split into 3 different horizontal bands: a foundation, a middle, and a summit. The foundation will account for the biggest amount of the pyramid's volume, while the summit accounts for very little. Each of these bands corresponds with a risk level for an investment � the foundation represents low-risk investments, the middle represents mid-risk investments, and the summit represents risky investments. The allocation of the pyramid's volume corresponds to the allocation of these investments in your portfolio.

Assess your needs and goals as an investor. Ask yourself questions to determine what level of risk you are willing to shoulder, and what level of liquidity you require. If you are close to retirement or if you will soon need money for a large purchase, you should opt for low-risk investments. If you are a young investor looking for long-term gains, riskier investments might be a better option.

Determine which investment vehicles you prefer, and where they should be allocated in the pyramid. Think about which types of investments you are comfortable with, and determine where they fall in the risk pyramid. Make sure to invest some of your portfolio in each risk category.

The pyramid's foundation represents low-risk investments. Treasury bills, money market accounts, certificates of deposit (CDs), and cash are all investments that belong in the pyramid's foundation. These types of securities should constitute the largest portion of your portfolio. The pyramid's middle represents mid-risk investments. Mutual funds, "blue chip" stocks, real estate, and highly rated bonds belong in this risk category. Allocate less to this category than to the foundation.

The summit of the pyramid represents high-risk investments. Futures, options, swaps, and "penny stocks" belong in this category. Even if you are an aggressive investor, beware of putting too much of your portfolio in this category.

Ensure that your investment goals and your pyramid allocation coincide. Once you have categorized all of your investments using the risk pyramid, determine if the level of risk you are shouldering is in line with your goals. Regardless of your particular needs, the pyramid should generally be "bottom heavy," meaning that there are more low-risk assets than high-risk ones.

Adjust your risk pyramid as necessary. Your investment needs will change with time, and your portfolio's risk level should change with it. As you approach retirement, for example, you should shoulder less and less risk.