Building a solid investment structure

The pamid structure above serves as a good representation of how your investment portfolio should be built. Generally, the riskier an investment, the smaller the part it should have in your portfolio. However, your investment plan must first address the basic principle of asset allocation — that diversifying your portfolio among the three main asset classes (cash, fixed income and equities) is the simplest way to reduce risk. Next, you must ensure that the individual securities you pick reflect your investment objectives and tolerance for risk.

As with any structure, it makes sense that the safest, most reliable components form the base of your investment plan. Here you have the money in your bank accounts, Canada Savings Bonds and Guaranteed Investment Certificates. However, though loss to your capital is a low probability with these cash-type securities, they also offer no potential for capital growth.

On the next level, you’ll find money-market mutual funds, which are actively managed to get the highest possible interest rate, and bonds issued by the government and by well-established corporations with sound credit records. These tend to be as safe as the investments at the base of the pyramid but offer slightly higher rates of interest and even the potential for small capital gains. You can count on the investments in the first two layers of they pyramid to sustain the riskier elements of your portfolio

As you move up the investment pyramid, both risk level and expected returns increase. Securities with moderate levels of risk and return include balanced mutual funds, which hold a mix of stocks, bonds and cash, and preferred shares, which are issued by companies that have good records of dividend payment. These investments can increase in value and offer the potential for growth. (Canadian dividend mutual funds, which focus on dividend-paying stocks, also belong here.)

The next level of the pyramid comprises investments with good growth potential and moderate risk: shares in well-established companies, diversified Canadian and U.S. equity mutual funds, and global and international equity mutual funds all fit here. Although your capital is not guaranteed, over the long-term these types of investments tend to have positive returns.

Options, which can be used speculatively to boost your potential returns exponentially and real estate belong in the next level of the investment pyramid. (As you’ll learn later in this publication, options can also be used to reduce risk.) Whether you hold property for the purpose of producing income or to profit from potential increases in market value, you should be aware that real estate is a fairly illiquid investment. In other words, you may not be able to sell for an acceptable price when you wish to.

Historically, the investments in the next level of the investment pyramid have made amazing gains but have also experienced drastic losses. The volatile securities found here include mutual funds that focus on single sectors (emerging markets or single countries, precious metals, resources or any other single industry), labour-sponsored funds, which focus on start-up ventures often in emerging sectors, low-grade corporate bonds, which often pay higher rates of interest in exchange for the greater credit risk of the issuer, and speculative stocks that have little track record of earnings.

At the very peak of your pyramid are futures contracts, which only sophisticated investors should consider. Although the potential gains can be great, investing in futures contracts is generally very risky and can result in disastrous losses.