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More Risk in the Market Place

Last week we discussed the role risk plays in the direction we each chose to reach our investment goals. One of the most helpful graphics in understanding this matter is what is called the Investment or Risk Pyramid. Any course of study dealing with investments will feature this graphic, primarily because of its simple nature in explaining the issues we all need to consider.

First, lets revisit a definition of risk as it applies to our current investment strategies. The most common definition is simply the risk we take that we might lose some or all of the money we invest. That's okay, but it fails to consider the opportunities or the lack thereof that are so meaningful today. A better definition would consider what is termed an absolutely risk-free investment as a benchmark reference. How about, "risk is the chance we take that we'll earn less from an investment than the interest available from insured savings certificates or U.S. treasury notes." Or more simply, the chance that we'll earn less than 4% or 5% on our money. If we can't expect to do better than that, there is no reason to take the risk.

Given that definition, lets look at the Risk Pyramid as a visual image to help reduce our risk. We begin with the pyramid divided into four levels, each level becoming smaller as it moves towards the top.

1. The bottom level has wide base of financial security:
   • a home
   • insured savings
   • insurance to cover health, auto, home, disability
   • cash
   
   
2. The next level, not as wide as the first, represents space available for some risk in our financial plan. Low-risk mutual funds are usually placed here along with low-risk dividend paying stocks. The greater the risk in an investment, the higher up it goes in the pyramid and accordingly, the less money we should put in it.
   
   
3. The higher we go, the more narrow the level. On the third step we have space in our portfolio that is available for investments involving more risk. The greater the risk of an investment, the higher up the pyramid it goes. And thus, the less money you should put into it. Real-estate investments are often placed on this level.
   
   
4. The top of the pyramid is for high-risk investments, the ones we are told not to get into: penny stocks, commodities, limited partnerships, etc.

For us, what is placed into each level is not nearly as important as the graphic itself. We must define for ourselves what we place into each level in our own pyramid. This does not mean we should avoid all high-risk investments. It means we must understand the risk/reward relationship we discussed last week and keep the high risk stuff at the top of our pyramid.

As we generate income from our rolling stock strategies, we must remain balanced and keep salting a portion of our returns into our base. The road to success is like driving from New York to Los Angeles. If our goal is Los Angeles, there are a multitude of paths we can take. Each path will have its own personality, its joys, its difficulties. In the same way, our path to success can be as varied. Our particular set of strategies need not copy those of any one guru. We must find our own.