Page 251 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes With a longer time horizon, investors have more time to recoup any possible losses and are
therefore theoretically be more tolerant of higher risks. For example, if $20,000 is meant for a
lakeside cottage that you are planning to buy in ten years, you can invest the money into higher-
risk stocks because there is be more time available to recover any losses and less likelihood of
being forced to sell out of the position too early.
Figure 9.1

Bankroll

Determining the amount of money you can stand to lose is another important factor of figuring
out your risk tolerance. This might not be the most optimistic method of investing; however, it
is the most realistic. By investing only money that you can afford to lose or afford to have tied
up for some period of time, you won't be pressured to sell off any investments because of panic
or liquidity issues.
The more money you have, the more risk you are able to take and vice-versa. Compare, for
instance, a person who has a net worth of 50,000 to another person who has a net worth of
5,000,000. If both invest 25,000 of their net worth into securities, the person with the lower net
worth will be more affected by a decline than the person with the higher net worth. Furthermore,
if the investors face a liquidity issue and require cash immediately. They will not invest in risky
projects.

9.3 Investment Risk Pyramid

After deciding on how much risk is acceptable in your portfolio by acknowledging your time
horizon and bankroll, you can use the risk pyramid approach for balancing your assets.
This pyramid can be thought of as an asset allocation tool that investors can use to diversify their
portfolio investments according to the risk profile of each security. The pyramid, representing
the investor's portfolio, has three distinct tiers:
1. Base of the Pyramid: The foundation of the pyramid represents the strongest portion,
which supports everything above it. This area should be comprised of investments that
are low in risk and have foreseeable returns. It is the largest area and composes the bulk
of your assets.
2. Middle Portion: This area should be made up of medium-risk investments that offer a
stable return while still allowing for capital appreciation. Although more risky than the
assets creating the base, these investments should still be relatively safe.
3. Summit: Reserved specifically for high-risk investments, this is the smallest area of the
pyramid (portfolio) and should be made up of money you can lose without any serious
repercussions. Furthermore, money in the summit should be fairly disposable so that you
don't have to sell prematurely in instances where there are capital losses.

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