Identify risks and risk pyramid

You may be familiar with the concept of risk return, 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 level of risk that their investment portfolio should bear. This article provides a general framework that any investor can use to assess the level of personal risk and the relationship between this level and different potential investments.

Risk reward concept

Risk-reward is a universal trade-off that can generate almost any return.Any time you invest money in something, there is a risk, no matter how big or small, you may not get your money backIn order to avoid investment failure. In order to bear this risk, you expect to get a return that compensates for your potential losses. In theory, the higher the risk, the more return you should get from holding the investment, and the lower the risk, the less return you should receive, on average.

For investment securities, we can create a chart that contains different types of securities and their associated risk/return profiles.

Although this chart is not scientific, it provides a guideline that investors can use when choosing different investments. At the top of the chart are investments with higher risk but may provide investors with higher potential than average returns. The lower part is a safer investment, but the high return potential of these investments is lower.

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Determine your risk appetite

With so many different types of investments to choose from, how can investors determine how much risk they can bear? Everyone is different, and it is difficult to create a stable model that works for everyone, but when deciding how much risk to take, you should consider the following two important things:

  • Time frame: Before you make any investment, you should always determine how long you must keep investing. If you have $20,000 to invest today, but you need to use it to pay the down payment for your new home a year from now, investing that money in riskier stocks is not the best strategy. The greater the investment risk, the greater its volatility or price fluctuations. Therefore, if your time frame is relatively short, you may be forced to sell your securities at a huge loss. With the extension of the time span, investors have more time to make up for any possible losses, so theoretically they are more tolerant of higher risks. For example, if the $20,000 is used for a lakeside cottage that you plan to purchase within 10 years, you can invest the money in riskier stocks. why? Because there is more time to make up for any losses, the possibility of being forced to sell positions prematurely is also less.
  • Funds: Determining the amount of loss you can afford is another important factor in determining your risk tolerance. This may not be the most optimistic investment method; however, it is the most realistic. By investing only money that you can afford to lose or can withstand for a period of time, you will not be forced to sell any investment due to panic or liquidity issues. The more money you have, the greater the risk you can take. For example, compare a person with a net worth of $50,000 to another person with a net worth of $5 million. If both of them invest $25,000 of net worth in securities, then those with lower net worth will be more affected than those with higher net worth.

Investment risk pyramid

After confirming your time frame and funds to determine the acceptable risk in your portfolio, you can use the investment pyramid method to balance your assets.

This pyramid can be thought of as an asset allocation tool that investors can use to diversify their investment portfolios according to the risk profile of each security. The pyramid representing the investor’s portfolio has three different levels:

  • The bottom of the pyramid: The base of the pyramid represents the strongest part, and it supports everything on it. This area should include investments with low risk and predictable returns. It is the largest area and contains most of your assets.
  • Middle part: This area should consist of medium-risk investments that provide stable returns while still allowing capital appreciation. Although more risky than creating the underlying assets, these investments should still be relatively safe.
  • Pinnacle: It is reserved for high-risk investments. This is the smallest area in the pyramid (portfolio) and should consist of funds that you can lose without any serious impact. In addition, the funds at the summit should be disposable, so you don’t have to sell prematurely in the event of a capital loss.

Bottom line

Not all investors are created equal. Although some people prefer lower risk, other investors prefer risk than those with larger net assets. This diversity has led to the beauty of the investment pyramid. Those who wish to increase the risk in their investment portfolio can increase the scale of the summit by reducing the other two parts, while those who wish to reduce the risk can increase the size of the base. The pyramid representing your portfolio should be customized according to your risk appetite.

It is important for investors to understand the concept of risk and how it applies to them. Making wise investment decisions requires not only studying individual securities, but also understanding your own financial situation and risk profile. In order to estimate securities suitable for a particular risk tolerance level and maximize returns, investors should understand how much time and money they must invest and the returns they are seeking.

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