Tuesday, November 17, 2009

Investment Pyramid: Just Wrong

For many years the personal financial industry has pushed an investment pyramid as a model. This pyramid is very similar to the food pyramid that many investors are familiar except that the sections deal with size of your risk-associated investments rather than healthy eating.

The investment pyramid has primarily served as sales tool for investment firms. One promoter is Edward Jones which wraps the pyramid into a pitch for their products. The common pyramid model has several levels with the most risky at the peak and the least risky at the base. The model is supposed to reflect the size of your investments in these type of assets.

It is becoming more apparent that this standard investment pyramid may be hazardous for your financial health. The pyramid does not take into account investment horizons and objectives very well; nor does it account for significant market draw-downs.

A better model effectively turns the investment pyramid on its right side and uses the bottom axis as time horizon. This places the most risky investments further out in time and least risky up close. However there needs to be more refinement to make this model successful than just tipping the pyramid over. Each slice needs to reflect a time period and a mix of investments; furthermore the size (or height) of the slice is driven by dollar amount of the need in the particular period. This means that the pyramid may possibly no longer get narrower in time depending on an individuals need later time periods may be larger.

Take a look at a typical family living in their first home with a couple of children. Their future needs are focused on buying a larger house in five years, saving for their kids' college education in 12 years, and their retirement in 25 years. Each of these time periods represent a slice, and each should be looked at from a perspective of the worst case draw-down and consequences based on the portfolio.

The down payment for the house in five years is probably a lot smaller than the college education bill. The down payment can not afford a large draw-down without the consequence of wiping out the families ability to move to a larger home. This investment slice may be small in size but needs to be placed in an investment portfolio with minimal risk. While the college investment slice is much larger but can support an allocation with increased risk.

A better name for this new model is Time Slice Investing or the TSI model. Each time slice needs to have a size, objective, separate portfolio, and risk modeling for an investor to be successful in the long term.