Every investment decision involves the selection of an appropriate financial security product. Financial securities come in different levels of complexity as well as risks. As investors (even the most experienced ones), we need to always understand where an investment product places relative to other products in terms of simplicity and risk/reward. The best (and probably the most cheesiest way) I found that can represent these elements is visually and the image to me that captures these relationships best is an onion because of its core and the various layers that surround the core which you can peel off.
Yes that's right, I've associated investing with something you sauté. Who would have thought?
The layers that are close to the core represent securities that have a low risk/reward and are simple in concept. As you branch out away from the core of the onion, the risk/reward level increases along with the complexity.
Below is a breakdown of the key areas of the Investment Onion:
At The Core (Low Risk)
These are your traditional low risk products that preserve your principal and pay you a modest income stream. Cash would be considered the purest form of “security” as it is highly liquid, however it is not without risks as inflation can eat away at its purchasing power. Money market mutual funds or Government T-Bills would play a close second, only because they can be susceptible to abnormal events such as the 2008 credit crisis. These type of products would reside at the core of the Investment Onion hierarchy. Moving to the next outward layer, you would find Government bonds with medium to Long-Term maturities, especially those from developed countries are also relatively stable as they are “guaranteed” by the government who has a printing press at their disposal. These type of securities are easy to understand. You lend the Government your money, they pay it back it by a specific date with interest to compensate you with parting of your money. These would be followed by Corporate Bonds.
When we move outward from the core, the risk/reward proposition increases. A corporate Bond will offer greater income opportunities than holding a Money Market mutual fund, however, you are taking on additional business/market/inflation risks. Finally we include preferred stocks mainly because they are more stable than its Common Stock cousin, however it is still susceptible to business risk of the company. Securities near the core also benefit from being at or near the front of the line in the event of any liquidation proceedings (i.e. bond holders are paid off before preferred shareholders who are a paid off before common shareholders. These type of securities are a bit more complex in that you have to have an understanding of the fundamentals of the business as well as an awareness of macro-economic variables, which is not hard to learn, but requires a commitment.
Middle Layers (High Risk)
As we continue to branch away from the core of the Investment Onion, we encounter even greater risk/reward propositions. These include the venerable Common Shares (individual stocks, equity mutual funds, and basic, low cost, Exchange Traded Funds), but also derivative securities such as stock options as well as high yield junk bonds.
Outer Layers (Very High Risk)
When we reach the outer rings of the Onion, we find a set of securities that have been historically reserved for professional traders. We’re talking about trading in currencies and commodities using highly sophisticated derivatives and trading algorithms that require you to be a major in quantum physics and even that doesn’t guarantee comprehension . Currencies and commodities are extremely volatile, and short-term in nature so you really have to be on top of a lot of economic and technical variables to keep up. Recently ETF’s have been introduced to allow individual investors to participate in these type of securities as well as make use of leverage to bet on securities going up and or down.
We’ve tried to list the main types of securities products. There are many more like REITS for example where your interpretation of where they reside in the Investment Onion may vary again, because everyone has a different comfort level with risk.
Most investors venture near the core of the Investment Onion and maybe venture as far out as buying individual stocks or equity ETF’s. For most of us, that is probably as far out as we need to be, however we are seeing more and more investors especially novice investors straying away from the core and investing in products that are extremely risky and are very difficult to manage or understand. Why? The main reason is that investments that reside near the core of the Investment Onion, pay very little in the way of interest income these days. Traditionally in these situations, investors would venture out to the middle layers of the Onion, but the financial industry has been marketing the outer layers of the Onion more aggressively to average investors because they know that these investors are searching for anything that can pay income. The short-term neurotic nature of the stock market and the emergence of day-trading systems are also enticing individual investors to move up the risk/reward profile.
It comes down to an awareness of our own individual risk tolerance because if we have low tolerance for risk, we should gravitate to investments that are near the core of the Investment Onion. If we are more knowledgeable and tolerant for making more aggressive investments AND we are educated and literate enough to understand their mechanisms, we could consider adopting investments that are away from the core of the Onion. For sophisticated investors, this approach for framing securities may seem beneath them but for those who are starting to invest, it can serve as simple reference point.
So the next time you are evaluating an investment product or when your advisor is trying to sell you a new hot financial product, try to visualize where you would slot it within the Investment Onion and make sure it is aligned with your own risk tolerance. Taking this approach will improve your chances of making an investment decision that will be successful and contribute to your financial goals. Who knows, it could also trigger a craving for onion rings.