Financial Pyramid Guides Investors for Life
Adds Realism of Risk-Reward Tests to Retirement Plans
May 7, 2009
As the diagram below indicates, the pyramid represents the approximate configuration that financial resources should take, in order to produce effective yields and risks during progressive stages of an investor’s financial condition. Although the concept is similar in all financial pyramids, some might be more expansive or compressed than the example.
Each tier of the pyramid supports the levels above or below it, by providing the financial stability to allow an investor to add more lucrative, risky resources above, in a timely and prudent manner; or to add more dependable resources below, by reducing others from the riskier, less liquid tiers above.
Proliferation of New Products Blurs Risk/Reward
Among professional investment managers, there are no tier contents etched in granite; for the rapid proliferation of financial products in recent years has introduced a plethora of untested products, in terms of risk and reward. New products on Wall Street spawn like salmon headed upstream and make the discipline of the pyramid more important than ever.
If investors could have foreseen the credit meltdown that began in 2008, set off by rampant defaults in the mortgages contained in securitized sub-prime, mortgage-backed bonds, the world might be better off today. More to the point, if the rating agencies had really looked hard, the bonds would have been assigned to an upper tier of the pyramid, rather than hiding with real bonds lower down, like the 800-pound gorilla.
Capital Preservation is First Tier and Foundation of Pyramid
In the first tier, the foundation, Preservation of Capital is the prime objective. These elements are vital to a person’s near-term sustenance and should be in place first. Suitable resources Include:
- Savings accounts
- Life insurance with cash values
- Defined-benefit pensions
- Certificates of deposits
- Checking accounts, with a balance of six months of living expenses
Second Tier Is for Income-producing Entities
The second tier calls for Income-producing items, dependable ones with regular long-term payouts such as:
- Municipal bonds
- Corporate bonds
- Fixed annuities
- Some variable annuities
- Insured municipals
- US Treasury notes and bills
- Personal property
- Residence
Growth and Income Objectives Come Next with Accent on Growth
Moving upward to the third tier introduces capital Growth and Income to the financial blueprint, but growth is weighted greater than income, as in:
- Mutual funds
- Managed investment accounts (except ones Bernard Madoff “managed”)
- Blue chip stocks
- Sale of covered call options
- Oil & gas producing programs
Fourth Tier Features Capital Appreciation or Growth
On the fourth tier, Capital Appreciation or growth appears, with growth over weighted. The lower tiers are producing income so that selections from the following groups can be added, with peace of mind:
- Speculative stocks (50 percent or less chance of paying off)
- Oil & gas exploration (where no drilling rig has gone before)
- Commodity pools of raw land or farm land
- Undeveloped investment real estate
Special Situations Cut a Wide Swath of High Risk
They occupy the fifth tier, sort of a catch-all for alluring “investments” of various sizes and shapes. (Sorry, except Las Vegas or Atlantic City):
The Special Situations group is the Carnival of investing. In the case of "collectibles," one investor's junk can be another's junque. The tier includes:
- Art
- Rare coins
- Gold & silver
- Precious stones
- Exotic metals
- Sale of uncovered call options
- Puts and calls
- Collectibles
- Futures contracts
- Derivatives
Concept of the Pyramid Stresses the Great Truth of Investing
The most important point about using the financial pyramid is that as the investor goes up the tiers in accumulating assets, the greater should be the risk and reward expected; and the farther down the tiers, the lesser should be the risk and reward expected. That architecture symbolizes the great truth of serious investing.
A middle-aged investor, who has begun thinking conservatively and wants to build up the first tier, might weight the tiers, from foundation to apex, in this manner: 40%-25%-15%-15%-5%. On the other hand, a younger, single planner might be more aggressive, with a 25%-30%-20%-15%-10% allocation. The pyramid adjusts the financial structure to accommodate planners' aspirations and needs throughout their lifecycles.
In choosing resources for each tier, there are trade-offs; quality is always sacrificed for capital growth and vice-versa. In deciding that a five-tiered pyramid with 20 percent of resources in each tier needs more income, assets from the highest tier should be sold and reinvested in Income-Producing securities or properties. In that way, items in higher tiers are automatically sold to lock in the gains or minimize the losses.
Note: The writer is a Chartered Financial Analyst.
 |
