Think back to the 2008 financial crisis, an event that highlighted just how vulnerable financial institutions were to market crashes and other economic downturns at the time. In response and to help minimize future bank failures, the government began requiring large banks to conduct annual stress tests: detailed analyses that determine whether banks have enough capital to withstand another crisis.

Now, consider your own investment portfolio. While you may be on track to reach your goals, you should know just how vulnerable your portfolio is to another prolonged economic downturn and the pressure this could place on your investment returns. This is especially true if your nearing retirement and lack the time necessary to ride out adverse market conditions.

This is precisely where a portfolio stress test comes into play and the topic we’ll cover in this post.

A portfolio stress test, defined

A stress test is a risk management tool that quantifies how well (or poorly) your portfolio might perform during an unexpected economic or market event.

During this process, several “what-if” scenarios are constructed based on real-life (as well as hypothetical) macroeconomic or geopolitical uncertainties that identify which parts of your portfolio are exposed in each scenario. Such uncertainties could include anything from the 2008 financial crisis or a 10% S&P drop to increasing unemployment, interest rate hikes, inflation spikes, rapidly rising healthcare costs, or even a foreign economy slowdown.

Various assets—including stocks, bonds, ETFs, mutual funds, and options—can accompany stress tests.

Portfolio stress test advantages

The biggest benefit of conducting a stress test is that it helps identify potential risks within your portfolio: meaning you’ll enjoy the ability to make any necessary adjustments in advance to mitigate potential future risks. One example of such a risk is perhaps having too much exposure to stocks within your asset mix or overexposure to specific industry sectors (such as technology or energy equities).

A well-conducted portfolio stress test will also provide realistic and insightful perspective regarding how much (or how little) progress you’re making towards attaining your financial goals. For example, you may want to learn if you’ll run out of money in retirement, have enough money to retire within the next 5 to 10 years, or even have the ability to maximize the inheritance you’ll leave for your heirs. Whatever your financial objectives, stress testing allows you to plan for worst-case scenarios rather than simply making broad assumptions (or even hoping) that your portfolio is well-equipped to withstand significant market downturns.

Risk tolerance and stress tests

Your risk tolerance (the ability and willingness to tolerate large swings in investment value) also plays a role in portfolio stress testing.

For example, a stress test might determine you need a 7% return to increase the chance you’ll reach your goals. In this scenario, you’ll need to identify how comfortable you are taking on additional risk.

While you can also adjust other levers (such as how much you save and spend), how you address these shortcomings is a matter of personal preference. More specifically, your strategy will often depend on how much risk you’re willing to tolerate.

To assess your risk tolerance, your financial advisor will typically furnish a questionnaire that asks several questions about various market scenarios (e.g., “What action (if any) would you take if the stock market fell by 15% over six months?”).

Your responses help your financial advisor determine how to best allocate your money based on how comfortable you are with risk. The higher your tolerance, the more likely it is your portfolio will include riskier investments such as stocks. A lower risk tolerance, meanwhile, could fill your portfolio with more stable investments such as bonds or certificates of deposit (CDs): all while considering your financial goals and time horizon (the period of time between the investment and when you’ll actually need that money).

Other portfolio stress test considerations

When conducting a stress test, you’ll need to understand a few key factors to feel more confident that your plan will hold up through the most challenging of times:

Saving & spending
We mentioned earlier that savings and spending are additional financial levers you can modify to help reach your goals, especially when test results indicate a high probability you’ll fall short of your objectives.

Knowing how much you’re saving and spending monthly (or annually)—rather than just guessing—is critical, as you may need to determine if you can either generate additional income or cut expenses to help fill the funding gap: especially if you aren’t comfortable taking on additional risk or adjusting your goals.

Growth rate
If your financial advisor uses super-aggressive growth rates for your projections, you may want to ask him/her to pump the brakes. Why? Because unrealistic growth rates—even by just a few percentage points—can significantly inflate the value of your projected assets and thus give you false assurances that your investments will likely withstand future market downturns.

A conservative growth assumption is therefore recommended to provide a more realistic picture. While 5% is a standard growth rate used (from what we’ve seen online), it’s important to not only learn which exact growth rate your financial advisor is using but also seek out an explanation for the same.

Inflation
Inflation is the continual rise in the average price of goods and services. While not all inflation is bad (perhaps contrary to popular belief), this phenomenon can adversely impact your retirement in many ways if not adequately accounted for. For example, let’s assume you plan to retire in twenty years and are saving $500 per month ($120,000 total) while earning an average annual return of 7%: in line with historical trends. In this scenario, you’d end up with $261,982.70. Assuming a 2.5% inflation rate (which is common, based on our research), the future value of your $261,982 is roughly the value of $159,880 now—meaning you won’t be able to buy as many goods and services. Your financial advisor must therefore account for inflation in any projections.

Finally, you should also know that a stress test is only effective if conducted at regular intervals and should therefore not be treated as a one-time event.

In sum: portfolio stress tests

While it’s impossible to predict the future, recessions and other events that adversely impact financial markets are fairly inevitable and will thus affect the value of your investment portfolio as well. Thankfully, a portfolio stress test can help place you in a better position by ensuring you aren’t over-exposed to such risks moving forward.

Are you worried you may have too much risk in your portfolio? Get a complimentary portfolio review and risk assessment today from one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.