Does your portfolio pass the “what if” test?
Investment and Asset Management
Many banks conduct regular “stress” tests to predict the impact of adverse external events on their earnings, capital, and loan portfolios. Banks use the results to shore up any revealed weaknesses. Investors should periodically perform the same kind of stress test on their investment portfolios.
Accentuate the negative
Stress testing is the ultimate “what if” analysis. It uses modeling techniques to predict the impact of an economic downturn, financial crisis, or any number of other “worst case” scenarios on your wealth. By analyzing this information, you can identify vulnerabilities in your financial plan and make changes to enhance its probability of success.
There’s virtually no limit to the scenarios you can test. Examples include:
- Extreme market volatility,
- A severe or prolonged bear market,
- Rising inflation or interest rates,
- An oil price crash, or
- A financial crisis such as the “tech bubble” bust that started in 1999 or the subprime mortgage crisis of 2007-10.
A useful exercise is to take the contents of your actual portfolio and calculate the outcome had you owned the identical investments on the eve of a historical financial crisis. Such testing can reveal potential weaknesses in your portfolio and help you pinpoint strategies to mitigate them.
For example, you might change the assumptions in your scenario analysis to see how your portfolio would respond if it were more heavily allocated to bonds rather than equities or if it were more diversified by region, sector, or other factors. While there are no guarantees, this type of stress testing can help you identify asset allocations that increase your probability of weathering various storms and ultimately meeting your financial goals.
Don’t eliminate the positive
Stress testing tends to focus on negative scenarios but doesn’t ignore the positive. Incorporating positive market developments in your scenario analysis — such as the resurgence of a struggling sector or improved stability in a volatile market — can help you ensure that you’re invested in the right vehicles to maximize upside potential.
Of course, stress testing can tell investors only so much. During the recent pandemic, many stocks soared despite economic conditions that would suggest they’d be under greater downward pressure. So talk to your advisor about the potential benefits — and limitations — of stress testing. Your advisor can help you develop a resilient financial plan that’s customized to your specific circumstances and goals.
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