Diversifying with the Investment Pyramid

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Diversifying with the Investment Pyramid

In the article "Pie vs. Pyramid: The Battle of Risk and Reward in Your Portfolio," the reasons behind the significant investment losses experienced in the last three years were attributed to, among other things, the Investment Pie Chart–an asset allocation model used by brokerage firms to illustrate diversification within mutual funds. The problem with the chart is two-fold: (1) it is rarely used to reflect diversification in your entire portfolio and (2) it disregards the Investment Pyramid, the oldest, most-widely accepted risk diversification model.

The Investment Pyramid lists types of investments according to their relative safety. The bottom of the Pyramid is comprised of lower-risk, including guaranteed investments; the middle is composed of secure and growth investments; and the tip of the Pyramid is devoted to speculative investments. Within the Pyramid, there is a ratio between the area allocated for guaranteed investments to the area reserved for secure, growth, and speculative investments. This relates to the percentage of a portfolio that an investor may want to apportion for certain investments.

Unfortunately, as important as the Investment Pyramid is to balancing your portfolio's risk, it is still lacking in one critical area: Time. Where should you be on the Pyramid and when? Is the Pyramid the same for a thirty-year-old investor, as it is for a seventy-year-old investor? Common sense would dictate that these individuals would not share the same investment strategies; after all, a thirty-year old has plenty of earning years ahead, while a seventy year-old is likely already retired. The fact that the Pyramid doesn't take age into account is a problem that has kept many from embracing this vital diversification model.

In 1999, in an attempt to close this investment information gap, F&H began developing a tool which would not only make the Investment Pyramid easily understood by consumers, it would also tackle the problem of time. Keeping in line with the Institute's goals, the tool would have to remain unbiased and assist consumers in weighing advice and making informed decisions about their financial plan. Before long, F&H had created what became known as the Financial Health Spectrographâ„¢ (take a look at the bottom of page 22 to see how we arrived at this invaluable tool).

If diversification means, "don't keep all of your eggs in one basket," the Financial Health Spectrograph shows you where all of your "eggs," or assets are currently positioned. In other words, it plots your assets across a spectrum of risk, according to your age. Through the use of bell curves, the Financial Health Spectrograph can communicate the "optimal" investment areas for a particular age group. There are two bell curves an investor can choose from, one that represents early years, or pre-retirement, and another that represents later years, or post-retirement.

The pre-retirement bell curve is positioned to the left of the spectrum, and allows for higher relative risk in your portfolio. As I touched on earlier, when you are younger, you have more earning years ahead of you and can afford to allocate a larger percentage of your portfolio to investments that offer a higher potential rate of return, but also have a higher level of risk. If you do lose a portion of your principal investment, you still have time to earn it back. The post-retirement bell curve is positioned to the right of the spectrum, and allows for less relative risk in your portfolio. As you get older, and you have fewer earning years relative to the number of retirement years ahead, minimizing risk becomes more important. The less earning years you have remaining the more attention you should focus on conserving your assets.

Incidentally, your highest value asset represents the height of the Spectrograph and everything else is scaled in relation to the value of that asset (For example, if your home was the highest valued asset at $200,000, the Spectrograph would be scaled to $200,000). Also, each color used in the Financial Health Spectrograph corresponds with those utilized in the Investment Pyramid.

Here are the four types you need to know:

  1. Blue represents safe or "Guaranteed" investments. These types lie at the foundation of the Pyramid and on the right side of the Spectrograph.
  2. Green represents "Secure" investments that are conservative, but not guaranteed. These are located above the foundation in the Investment Pyramid and to the left of the blue area on the Spectrograph.
  3. Yellow, a cautionary color, represents the "Growth" section of variable, non-guaranteed investments. These investments are located below Speculative and above Secure on the Investment Pyramid and to the left of the green area on the Spectrograph.
  4. Red, the danger color, represents "Speculative" investments, which are considered risky. This area lies at the tip of the Investment Pyramid and on the extreme left end of the Spectrograph.

One point that needs to be stressed relates to the applicability of the Financial Health Spectrograph. The Spectrograph illustrates an ideal distribution of assets, but everyone's financial circumstances are different. Because of this, it is recommended that you consult with a licensed financial professional trained on the Spectrograph to determine the timing of when the shift between pre-retirement and post-retirement strategies may be best initiated. Another point to remember is that the Spectrograph offers no recommendations nor does it provide any solutions. It is meant as a diagnostic tool that illustrates where your assets lie in relation to the pre-retirement and post-retirement phases of life.  One thing is certain, it is a one-of-a-kind tool that's not only easy to use, it helps re-introduce investors to one of the fundamental elements of sound financial planning.