PYRAMID OF INVESTING

Art

Stamps

Gold/Precious Metals

Diamonds/Precious Stones

Uncovered Options/Currency Hedging

Commodities

General Partnerships, Penny Stock

Limited Partnerships- Real Estate, Oil,

Equipment Leasing

Non Diversified/Non Monitored Portfolios of Sector

& Junk Bond Mutual Funds

Rental Commercial/Residential Real Estate

Non Diversified Portfolios of Individual Issue-

Stocks and Bonds, Closed End Funds & REIT's

Covered Option Writing

Money Market Savings Accounts and CD's

Variable Annuities and Life Insurance

Fixed Annuities, Whole & Universal Insurance

Diversified & Monitored Stock & Bond Portfolios

Conservative & Monitored Portfolio of Mutual Funds

Home, Basic Life Insurance Policies, Invested Retirement Accounts

Overview: This pyramid is viable for a middle income family where the parents are around 40 years of age. More aggressive portfolios (more stock) are usually recommended for those younger and/or single while more conservative (more bond) investments are generally recommended for retirees. That is not caste in stone however, and depends on many variables. The ability to invest at any level must address a budget and the individual's current and future needs.

The essence of this simplistic exercise is to emphasize the basic risk/reward parameters. You should not invest in the more risky ventures until/unless you have covered the less risky areas first. It should be clear, therefore, that one does not utilize gold, precious metals, uncovered option writing or the use of single issue securities until the more conservative issues have been addressed- such as having enough insurance for your family. If you violate these basic rules, you are probably not bright enough to do good investing either.

Basic Life Insurance: The reference is to the insurance element only- not some investment angle. Families should always have insurance protection for the breadwinner(s). Additionally, other insurance for home, car, liability, boat, etc., needs to be addressed before attempting any investment.

Invested retirement accounts- This relates to 401(k) plans, IRA's and the like where the individual can invest funds for retirement. My point is that these account are invested in some growth vehicles and therefore are more conservative than investing solely in money market accounts which provide nil growth or security for the future.

Mutual Funds- By definition, mutual funds are diversified (at least 50 stocks). A conservative fund might be considered to be those with beta's of 1.0 or under (though more detailed analysis is preferred). And while most investors seldom monitor stock or pay for outside assistance, it can/does make a material difference over time and worth the effort. The first level is the passive and "cheap" approach through index funds. After that, one could consider managed funds.

Diversified Individual stock and bond portfolios- the use of individual stocks and bonds is more risky- and usually more expensive (due to commissions)- if one attempts to do it themselves. These portfolios MUST be actively monitored. In reality, the odds of successfully using single issue securities is remote.

Fixed Annuities, whole  life insurance- these policies earn income on a tax deferred basis (possibly tax free with insurance policy loans) and are essentially risk free as regards the guarantee of payment later on. (Admittedly the default of Executive Life and other insurance companies puts the guarantee in a subjective position, but most A and A+ A.M. Best rated companies should hold up well over time.) I have shown them to be more risky than properly utilized mutual funds since, even with tax deferral, the returns are reduced by inflation and access to funds may be severely reduced by surrender fees and the 10% penalty tax if removed from a policy prior to 59 1/2. As regards annuity payouts, these maybe absolutely dismal further subjecting retirement income to inflation.

Variable Annuities and Insurance- these policies can provide a higher return since they use mutual funds, but they can involve substantial fees much higher than basic policies and they also incur the 10% penalty if used before 59 1/2. Also, many are fixed during the payout period and subject the annuitant to inflation as described above.

As regards insurance, it is possible to build up a kitty inside a life policy but the illustations generally provided rarely address the risk of low returns and the implications on the survivorship of the policy. For example, the negative returns of 2000- 2003 may even require an influx of money at a later point in order to keep te policy afloat. It is preferable to buy insurance just for insurance and keep the investments separate.

Money market accounts and CD's- these are shown as having a higher risk than most texts would imply, but due to the significant drop in rates during the early 90's, the after tax, after inflation return is minuscule at best. Middle income wage earners are getting essentially nothing for their effort if they "invest" here. The same situation has existed in 2000- 2003. These accounts are generally holding places till a better investment comes along.

Covered Option Writing- Though people owning individual stock can do covered option writing, it can be utilized to generate additional income. Caution is noted however that if the underlying stock has a low basis and is called away, a significant tax event may occur. Potentially viable in a flat or down market- though the downside is only protected by the amount of the price of a call.

Non diversified portfolios of stock or bonds- These generate a significant amount of unsystematic risk since the movement of a single stock can seriously erode the entire holdings. This is most common with companies that offer discounts for a company's stock with the end result that wage earners put too many assets in one place- Exxon, Worldcom being "fine" examples

Rental real estate- singular ownership of real estate has provided many past investors substantial returns. However, investors must recognize the personal management they usually must have in running such operations- leasing, maintenance, evictions, etc. and it is not as easy a return as many would have most consumers believe. Further, the tax laws can change dramatically- witness the 86 tax act- as well as the economy- witness the recession of the early 90's. In addition, real estate is a non liquid asset and the mortgage payments and time to sale can reduce equity to zero. And with inflation probably staying low for many years, investors cannot depend on the high appreciation of the 80's and 2000's and must calculate their potential return with a much longer holding period. Though the use of Real Estate Investment trusts do reduce the individual exposure, too much real estate, in itself, is not recommended.

Closed End funds- These are similar to open ended managed mutual funds but are issued with a fixed capitalization (caveats apply). They are bought in the same method as stock. But the real difficulty in analyzing their possible return is that they tend to be sold at a discount to Net Asset Value. Unless their track history is considered, many investors may simply purchase these with incomplete understanding.

Sector mutual funds- these must have at least 25% of their portfolios invested in a particular area- health, communications, etc. And when too much is placed in a risk area, it usually is not ultimately beneficial to the investor who rarely understands the risk. Clearly evidenced by the use of tech stocks in the 90's.

Limited Partnerships- Prior to the tax law change of 1986, many partnerships did very well indeed. The purchase of LIMITED amounts of partnerships was generally considered acceptable for middle income wage earners. However, many firms "forgot" that these were long term high risk ventures and sold units in excess of an investors risk tolerance/acceptance. Couple all of the above with a recessionary economy and many went into default. Some partnerships do continue to work and are even viable today, but the risk orientation limits their use.

General partnerships, precious metals uncovered option writing, etc.- These require a sophistication far in excess of the normal middle income wage earner and should be discouraged. Far too much risk and far too much to go wrong. Individuals using such investments must have considerable wealth and a thorough understanding of risk- or advised by a knowledgeable adviser.