The concept of risk and return is not something new among today’s investors. The concept generally states that the higher risk we take the higher return we would make. Risks and returns naturally go hand in hand and it is something that investors need to be aware of. Be that as it may, the ability to determine the level of risk that an investor’s portfolio could bear to get an optimum asset mix is a paramount concern to all investors.
This is what is known as the risk tolerance limit. At the end of this article, readers will be able to categorize their investment products risks and how it affects the construction of their portfolio pyramid.
Hope and Fear in an Investment
According to the modern portfolio theory, all investors are deemed to be rational and therefore, they are assumed to be able to make sound investment decision. This includes the ability to look into their investment portfolio as a whole especially in considering the level of risk and return of an investment. Nevertheless, an increasing number of studies have shown that in actual fact, emotional aspect plays a very prominent role in driving the investors’ portfolio structure. Investors tend to separate their investments, to provide for margin of safety and to ensure that their primary goals are first met before they take on higher risk to reach for other secondary goals.
Fear and hope were found to be the major emotions that determine the risk tolerance level of an investor. Fear often leads to anxiety and the need for security while hope will develop into anticipation for upside potentials. Collectively, these two contradictory emotions will determine the risk tolerance limit of an individual. Consequently, it will affect how they structure their investment portfolio.
What is a Portfolio Pyramid?
More and more investors are layering their investment portfolios in a pyramid structure, with the base of the pyramid portfolio representing the lowest risk investments. Risk investments increases as the investments portfolios move up to the top of the pyramid.
Base of the pyramid
The foundation of the portfolio pyramid is usually made up of the lowest risk investments, such as money market, government bonds and certificates of deposit that can provide security. When time horizon is short and the safety of principal is a priority, (which includes retirement fund or children’s education fund) the fear of not achieving the principal goal will drive investors to secure their money in those specific goals in the safest category.
Center of pyramid
This category usually consists of riskier investments such as high grade corporate bonds and blue chips stocks. These provide consistent income and at the same time offer the potential of capital appreciation. Investors who are looking for more predictable income while aspiring for some upside potentials to preserve the purchasing power of the capital will usually invest in this category. In general, the capital that the investors put into this category is meant for a longer term goal.
Peak of pyramid
Investments at the peak of the portfolio pyramid are the riskiest. It usually consists of high risk equities or alternative investments, such as small cap stocks, futures or options. After providing for the primary and specific goals, a small fraction of their savings (usually not more than 5% of the total portfolio) is allocated to be invested in speculative investments. The highly speculative investments that they make using this money actually provide them with anticipation and excitement, so much so that some investors term the money in this category as a ‘mad-money account’. Money made from here will be used to spend on luxury items and lifestyle that they dream of and if they lose money here, it will not hurt their primary objectives.
An investor who is very close to achieving and realizing his financial goal will most likely focus his money in the low risk investments first. This will broaden the base of his investment portfolio. However, if the current low risk investments he make is jeopardizing the primary goal that he wants to achieve, then, most likely, he will invest in riskier products to reduce the time and increase the chances of reaching his goal. The amount that investors put into each category in their portfolio pyramids will depend on their risk tolerance limit. As mentioned above, this is largely driven by the investor’s fear and hope in an investment.
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