Risk is everything. From our personal lives to investing, risk can be found everywhere and it is almost impossible to forego all of it. So, we undertake risk, hoping it will play out in our favor. Sometimes it does, other times it doesn’t. This is how the balance is maintained in everything.

High risk doesn’t necessarily mean bad things. It just means that there are more chances for your end goal to be missed. But, the way of the world is such that high risk is rewarded better. This is where the concept of ‘risk-reward’ is given birth to.

High risk = high reward
Low risk = low reward

None of these are inherently bad. The choice between these two depends on your personal risk tolerance.

Risk tolerance is your appetite for taking risks. How much are you ready to lose, for the off-chance to be rewarded more. Or, how little are you ready to lose, for more-or-less guaranteed rewards. You are a risk-taker if you are willing to lose a lot to potentially gain a lot, and you are risk-averse if you are not willing to lose much and will be satisfied with moderate gains.

The stock market is built around the concept of risk and reward. Every investment move you do is bound by risk. This is why the golden rule of investing should be reminded all time: “never invest more than you can lose.” What this simply means is that be prepared to lose everything you dump into the stock market.

If you take a risker approach to invest, you are also called an aggressive investor. If you take a steadier approach to invest, you are called a conservating investor.

However, the stock market is designed as such there are investment opportunities for all kinds of risk-takers. Different investment instruments are designed with different risk levels embedded within them.

Now that we have some sense of what risk is and how it plays into investing, next we will take a look at how you can manage your risk with different instruments in the stock market.

The Investment Risk Pyramid

A pyramid is used in many instances to show the proportion of one or more components against each other. The Food Pyramid, for example, shows how much of each type of food you should consume to intake a ‘balanced’ meal.

The Investment Risk Pyramid is a graphical representation of the relationship between different investment options in the stock market and their embedded risk levels.

This investment risk pyramid is divided into three sections; Base, Middle, and Summit. Notice how the Base is the largest portion and the Summit is the smallest portion. Also, notice how Base is towards the low-risk region and Summit is towards the high-risk region.

So let us evaluate how risk plays into these financial instruments.

Base – Low Risk

When we look at the base of the investment risk pyramid, we will come across some familiar names; cash, bank accounts, debt, and government bonds.

Keeping cash with you is possibly the safest way to not lose it (disregarding theft, wear and tear, etc.). Because $100 you have today will be the same amount in a week or a month. There is no chance for this money to be lost. This money does go down in value, though, thanks to inflation. But inflation is not the cornerstone of the discussion right now.

Let’s take something more interesting than keeping cash in your wallet. How about putting money in a savings account in a bank. Usually, the financial institutions in a country, such as banks, are some of the safest ways to protect your money (even safer than keeping it in your wallet). Banks will store your money with them and even give you an interest in return. This interest negates the effects of inflation on your money to some extent, so generally speaking, money in a bank account is better than holding cash in your wallet.

You can also buy government bonds with your money. This is where the governments of countries issue debt instruments, called bonds, to cover up for their cash deficits. Bonds will have a maturity date on which your money will be paid back in full with interest. You will be literally investing with the government. So, these are as safe as they come. Governments will borrow more money to pay any due bonds.

Treasury bills or simply bills are also government debt instruments. Unlike bonds which are long-term, bills are short-term. But both bills and bonds carry similar traits.

Your approach to Base

Investing in any of the securities in the base region of the investment risk pyramid warrants you the lowest risk possible. However, according to the risk mantra; low risk = low rewards. Bank interests, bond interests, certificate of deposit (CD) interests are all quite low. Most times, these interest rates do not even beat the country’s inflation which results in you losing the actual value of money over time. So, you should not keep all of your money in the base region, but based on your risk tolerance, some money should be retained here to keep you afloat.

Middle – Medium Risk

This is where the investment risk pyramid ranks the stock market at. Generally, the stock market is a long-term investment game. However, stock prices can go up or down and some companies could even go bankrupt. So your money is not bulletproof in the stock market.

Also, different companies, sectors, and business models carry different risk levels. So, picking out these stocks to suit your risk tolerance is the key.

Mutual funds and exchange-traded funds (ETFs) are a collection of investments – mostly consisting of shares of companies. However, they can have other securities from different risk categories as well. For example, an ETF can have a collection of government bonds for safe yields and a collection of covered calls for high yields, thus giving you the best of both worlds.

Your approach to Middle

Middle of the investment risk pyramid is where you should aim to be. This is where your money works for you with relative safety. If you are a risk-averse investor, keep this portion low or equal to the Base portion.

Summit – High Risk

Summit or the top of the investment risk pyramid is where risk really takes over your money.

Both Futures and Options are investment instruments that carry very high risks. But if you do strike your ‘luck’ or your investment strategy bears fruit, you have the potential to multiply your money in a very short period. On the flip side, there is an equal chance to lose all your money as well.

Novice investors should not dabble in this region of the risk pyramid.

Collectibles are quite different though. A Michael Jordon signed cap will not likely drop value over time. But nothing is permanent. There will be a time when the great MJ is not as appealing as he is today. There will come a day when Pokemon cards are not as valued as today.

Your approach to Summit

Essentially, you should only hold a little of your money in this region. You should still have some cushion money in the Middle or Base to fall to if in case your risky moves don’t pay off. In the Summit, you should absolutely be prepared to lose all your money and not let this break you down.

Investment Models from the Investment Risk Pyramid depending on Your Risk Tolerance

The below models are just to give you an opinion of what each risk tolerance is supposed to be. These are in no way suggestions for you to base your investments on.

• Risk averse / conservative investor: 75% in Base & 25% in Middle or 50% in Base & Middle each
• Moderate risk: 50% in Base & Middle each or 70% in Middle & 30% in Base
• Risk taker / aggressive investor: 25% in Summit & 40% in Middle & 35% in Base

Keep in mind that whatever you keep in the Base region should be able to sustain your lifestyle even if you lose everything else. We can even call this the amount required for your emergency fund.

Let us know what you think about this article in the comments below. Drop your risk tolerance level and your investment picks in the comments.