Definition and Example of Investment Pyramid
An investment pyramid is a tiered pyramid that helps investors get some context for what the general risk and reward level is for a certain investment. While an investment pyramid can’t predict how well an investment will perform, it can help investors pinpoint what types of investments are likely good fits for their risk tolerance.
- Alternate name: Investment risk pyramid
For example, the first tier of the pyramid includes savings accounts. As a tier-one investment, savings accounts may be a good fit if you want to avoid risk, because they provide a way for you to gain interest on your savings with virtually no risk. That said, the reward level for a savings account is low. An investor looking to earn better returns may want to consider stocks, which, while riskier, have the potential to net more rewards.
Note
The investment pyramid can help an investor consider these risk and reward factors to make an investment plan they feel comfortable with.
How Does an Investment Pyramid Work?
An investment pyramid has a series of tiers, with the broader bottom tiers offering lower risk and the smaller, higher tiers offering more risk. The number of tiers an investment pyramid has depends on the broker or financial institution making the pyramid. Here is an example of a five-tier investment pyramid:
Tier One
The bottom tier of the investment pyramid represents the investments that have the lowest risk and the lowest rate or return. These are considered to be “safe” investments and include:
- U.S. government securities: This includes savings bonds, Treasury bills, and Treasury notes and bonds.
- Federal agency securities: These are debt securities that come from Ginnie Mae, Freddie Mac, and Fannie Mae, and are bought and sold on the stock markets.
- Saving and checking accounts: Savings and checking accounts are as safe as it gets because they are insured by the FDIC.
- Certificates of deposit (CD): A CD is an investment that has a guaranteed outcome and a slightly higher interest rate than a savings account.
Money-market funds and fixed annuities could also be considered tier-one or base-level investments. Because the investments in the bottom tier offer low returns in conjunction with low risk, they are in jeopardy of inflation risk.
Tier Two
The second tier of the investment pyramid is made up of low-risk, steady-return investments such as municipal and corporate bonds, preferred stock, and convertible securities. The investments in the second tier are considered to be somewhat safe, but they share the bottom tier’s inflation risk.
Tier Three
Tier three is home to relatively low-risk investments that have a higher rate of return than the bottom two tiers. This tier includes blue-chip stock, growth funds and portfolios, balanced funds and portfolios, and variable annuities. While considered fairly stable, these investments tend to come with a better rate of return than what you’ll find in tiers one and two.
Tier Four
In tier four, you'll find stock and stock funds, including large-, mid-, and small-cap stocks. The small- and mid-cap stocks hold more risk than the large-cap stocks do. Mutual funds also fit into this tier, which allow investors to invest in multiple companies at the same time by purchasing one fund.
Tier Five
The very top of the investment pyramid represents the riskiest investments; options, futures, and speculative stocks and bonds are found here. While the payoff can be big, so can the loss. For example, certain futures contracts can put you at risk of infinite losses.
Note
Some investment pyramids use a three-tier approach, dividing investments into three groups: low-, medium- and high-risk.
Pros and Cons of an Investment Pyramid
Pros
A good introduction to investment risk levels
Provides clarity
Cons
You make the final investment call and hold all the risk
Lacks nuance
Pros Explained
- A good introduction to investment risk levels: The investment pyramid is a great way to quickly learn more about which types of investments are considered riskier than others.
- Provides clarity: If you’re struggling to decide how to invest your money, the investment pyramid can help you compare and contrast your options.
Cons Explained
- You make the final investment call and hold all the risk: The investment pyramid is more of an educational tool; you’re the one who has to make the final decision on how to invest your money, and you will take on all of the risk.
- Lacks nuance: The investment pyramid can give you a general idea of which types of investments are historically riskier and more likely to generate large rewards, but it doesn’t take into account that all investments are unique.
What It Means for Individual Investors
Investors who are new to investing and aren’t ready to hire an investment advisor can use the investment pyramid to get a sense of what type of investments are good fits for their risk-comfort level. That said, you can’t make an informed decision about how to invest your money simply by looking at an investment pyramid. You also need to do your own research on each investment option you’re considering.
Here are a few questions to ask yourself before you choose an investment vehicle:
- What kind of yield can you expect from this investment?
- What is the return you want, and what type of return is common with this type of investment?
- What is the risk you’ll be taking on?
- Can you sell or convert the investment into cash if need be, and how much would it cost to sell it?
Key Takeaways
- An investment pyramid is a visual tool that provides context surrounding which types of investments have more or fewer risks or rewards associated with them.
- An investment pyramid has tiers that range in risk and reward, with the bottom tier representing the safest investments that also have the lowest chance of rewards.
- The highest tier typically represents the riskiest investments with the highest potential rewards.
