An investment pyramid, or risk pyramid, is a portfolio strategy that allocates assets according to the relative risk levels of those investments. The risk of an investment is defined in this strategy by the variance of the investment return, or the likelihood the investment will decrease in value to a large degree.
The bottom and widest part of the pyramid is comprised of low-risk investments, the mid-portion is composed of growth investments, and the smallest part at the top is allocated to speculative investments.
Key Takeaways
The investment pyramid is an asset allocation strategy that investors use to diversify their portfolio investments according to the risk profile of each security.
The pyramid, representing the investor's portfolio, has three distinct tiers: low-risk assets at the bottom such as cash and money markets; moderately risky assets like stocks and bonds in the middle; and high-risk speculative assets like derivatives at the top.
The strategy calls for allocating the largest proportion of capital to the low-risk assets at the bottom, and the smallest amount to the speculative assets at the top.
An investment pyramid strategy builds a portfolio with the lowest risk investments as the base, equity securities of established companies as the middle, and speculative securities as the top.
The base (i.e. the widest part of the pyramid) would contain the highest allocation of assets and would include cash and CDs, short-term government bonds, and money market securities.
The middle part of the pyramid would include a moderate allocation to corporate bonds, stocks, and real estate. These assets are somewhat risky and have some probability of losing value, although over time they have positive expected returns.
The top would include the smallest allocation weights and include highly risky, speculative investments that have a high chance of loss, but may also produce above-average returns. These would include derivatives contracts like options and futures (not used for hedging purposes), alternative investments, and collectibles such as artwork.
Within each risk layer of the pyramid, you see an increase in risk taking, but with a smaller allocation of overall funds available to invest. As a result, the higher you go up the pyramid, the greater the risk, but also greater the potential return.
Note that not all investors have the same willingness and/or ability to take on risk. The pyramid representing a portfolio should be customized to an individual's particular risk preference and financial situation.
Example of an Investment Pyramid
As an example, Harold went to his financial advisor for advice on how to position his portfolio. The advisor suggested that based on Harold's goals, risk toleranceand time horizon, he should adopt an investment pyramid strategy. The advisor suggests that Harold put 40-50% of his portfolio in Treasury bonds and money market securities, 30-40% in mutual funds that invest in corporate stocks and bonds, and the rest in speculative items such as futures and commodities.
An investment pyramid, or risk pyramid, is a portfolio strategy that allocates assets according to the relative risk levels of those investments. The risk of an investment is defined in this strategy by the variance of the investment return, or the likelihood the investment will decrease in value to a large degree.
The basic rule of the pyramid is to start from the bottom and move up, rather than attempting to address all aspects of it at once. The four levels of the pyramid are (starting from the bottom): protection, savings, wealth building and speculation.
The pyramid is an asset allocation tool that investors can use to diversify their portfolios according to the risk profile of each security type. 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.
For example, one old rule of thumb that some advisors use to determine the proportion a person should allocate to stocks is to subtract the person's age from 100. In other words, if you're 35, you should put 65% of your money into stocks and the remaining 35% into bonds, real estate, and cash.
The benefit of pyramiding is that investors buy more once the trade starts moving in their favor. However, it is risky because it may happen that after an investor has increased its margin, the stock price declines or falls below the profit margin.
The success of pyramid schemes is usually limited to founders and early-stage members. These people fraudulently attract new, fee-paying members eager to make a promised quick and large monetary return. These members then recruit more fee-paying members.
Level 1 assets are those that are liquid and easy to value based on publicly quoted market prices. Level 2 assets are harder to value and can only partially be taken from quoted market prices but they can be reasonably extrapolated based on quoted market prices. Level 3 assets are difficult to value.
The Four Fund Combo is built on four index funds (or exchange-traded funds) that include the most basic U.S. equity asset classes: large-cap blend stocks (the S&P 500 SPX, +0.27%, in other words), large-cap value stocks, small-cap blend stocks, and small-cap value stocks.
The greater the risk of an investment, the higher up the pyramid it goes and, thus, the less money you should put into it. At the very top of the pyramid go the investments that few people should try, such as penny or microcap stocks, commodity futures contracts, promissory notes and most limited partnerships.
Diversification is one of the most fundamental rules of investing and allows you to take a middle road through the extremes of market performance, allowing your investment to grow regularly with smaller fluctuations along the way. Diversification is the most effective means of managing risk.
Your asset-allocation should not change as per the expectation of returns from various assets. Rather, your asset allocation should be based on your investment objective, risk-appetite and the years left to achieve the financial goals.
One guideline suggests that your stock allocation should equal 120 minus your age. For example, a 60-year-old's portfolio would consist of 60% stocks (or less if they're particularly risk-averse). Source: Stock Allocation Rules. Investopedia, July 11, 2022.
Pyramid Scheme Example 2: Wealth Pools International
New participants purchased a set of DVDs which they would then try to resell for profit. However, participants profited by recruiting new sales associates, and not from DVD sales.
A pyramid scheme can take many forms, but generally involves the promise of making money by recruiting new people. Pyramid schemes are illegal, and most people lose money.
Pyramiding is adding to a position to take full advantage of high-performing assets and thus maximizing returns. Averaging down is a much more dangerous strategy as the asset has already shown weakness, rather than strength. From a trader's perspective, pyramiding actually reduces riskiness.
The Rule of 72 is a calculation that estimates the number of years it takes to double your money at a specified rate of return. If, for example, your account earns 4 percent, divide 72 by 4 to get the number of years it will take for your money to double. In this case, 18 years.
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