A majority of the question of how to invest for retirement is about what to invest in, so how to structure your assets. The classic answer to this question is the investment pyramid.
The idea is to have a large part of your savings in low-risk asset classes, forming the base of the pyramid. Part of this foundation can be safe (!) real-estate or high-quality bonds. A very typical example ist he house you live in. Having seen the market turbulences of the last years, keep in mind that just because you live in it, does not mean that the market price is at ist real value and that the investment is safe. The benefits are that you do not rely on finding a renter and you have the (sometimes limited) choice on when to sell.
Above that, you should allocate a smaller amount to assets with a little more risk. This can be stocks of „boring“ companies, having limited upside potential, but a long track-record of steady earnings. Examples could be major players in the oil industry as well as energy and food suppliers. However, investing in individual stocks requires a good understanding of the company and the risks that come with the investment. Another example of course would be bond with a lower quality rating and higher interest than the ones for the foundation of your portfolio.
The next category has again increased risk and higher earnings potential. This can be stocks of quality companies, leaders in their (growing) industry or innovative challengers. In this category, we are willing to accept more risk, however, each investment we choose must look promising and absolutely convincing. A track-record of growth and an attractive product portfolio in its early stages is key to qualify for this category. Examples currently are Apple or BMW. Make sure the price is not too high compared to the current earnings and the expected earnings of the next years.
The highest risk class forms the top of the pyramid. The potential of these investments can boost the yield of the overall portfolio, while the very limited size restricts the potential loss. There are no formal restrictions on investments in this category, so common sense and the fear to loose your hard-earned money are the real limits. Investments of this category can be options, hedge funds, very risky individual stocks or junk bonds.
Percentage distribution – how steep is the pyramid
So far, there are no percentages assigned to each category. It is up to you to do this, just as it is up to you to stick to these percentages. Consider the pyramid as a tool to help you understand the risk structure of your investments; The extend to which your portfolio will reflect the pyramid will vary over time. However, I recommend to define and document a percentage number for each category and review your actual portfolio against this structure periodically. The idea is not to avoid risk, but to actively decide how much risk you are willing and able to take and how much you are actually taking with your current investments.
An example could be a 40/30/20/10 distribution, from base to top. However, this is very aggressive, as it has a rather small amount in the low risk categories and a very high amount in high risk assets. This does not mean it is wrong or bad, it might be appropriate for a wealthy entrepreneur, who is able to take risks and relys on the income associated with it. If you have less than a million USD and are currently saving for your retirement, you will most likely choose a more conservative asset allocation structure. Keep in mind, owning the house you live in will probably form the base of your investment pyramid.
Together with the percentages, you should also define and document precise definitions of each category. That way, whenever you add a stock to your portfolio, you will match it to these criteria and consider the risk of your new investment.
Benefits of this structure
So why are we doing all this? The challenge we are facing is earning a high yield with our investments without putting us at risk of loosing our assets at the same time. These goals are contradicting, so we have to find the balance between them that is appropriate for each individual situation. Clearly, having the lowest risk at the bottom of the pyramid shows that limiting risk is higher valued than maximizing return. It must be, if we loose our assets, we also loose the ability to generate income from it. The pyramid is a tool to define the risk structure we want. Our actual risk structure will never precisely match this, but a frequent comparison will guide us in the decisions we will make.
Having said all that, the investment pyramid shows us one dimension of risk and way to deal with it. However, there are many more and there is a lot more to understand about all of these and the investment pyramid is just a good start in the world of investment. Before you actually start investing you money based on your intended asset allocation, it is important to understand one more measure to reduce risk: diversification. If used in the right way, it is probably the most powerful tool you will ever have to keep control of your money. Investment advisors and sales people will often try to lure you away from proper diversification, as it limits the share of your wallet they hope to get. And yes, you will hear stories about people who invested all their money in one thing and won big time. This will not be you if you diversify properly! However, for each big winner, there are thousand of those who lost all their money, having it invested in one place (e.g. pension fund of Enron).
So bringing both concepts together, you should for each category have several investments. Different patterns are possible, you can invest the same amount in each investment or distribute according to your personal preferences. Also, the total number of your investments is completely up to you. It does take time to review the performance of each investment (you should do this exactly once a year) and the fees will be higher for smaller investments. You can offset this by choosing a discount broker with low fees, so it should not bet he factor. Personally, I favor having a large selection of securities and diversify heavily. Others do not own more than ten stocks at any time and prefer to invest more time in the research of each company.
The investment pyramid
May 3, 2012