How a Portfolio Stress Test Helps Balance Investment Risk and Reward
Portfolio stress tests have gotten a lot of attention from the media lately. It’s hardly a new concept; every year, the Federal Reserve conducts a stress test of the thirty largest financial institutions to figure out how they’d react in the event of an extreme financial crisis. Our goal is to make sure you understand what it is and how it works for you as an individual investor.
Basically, a portfolio stress test is a calculation of risk management. Its purpose is to help you and your financial advisor figure out how your investment portfolio would react under stress in a variety of scenarios, some transient and some ongoing. If you were planning to buy a new car; you’d probably take into consideration the car’s safety ratings (e.g., how it fared in crash tests) in addition to how well it performs. In effect, you’d try to figure out how to balance the trade offs between performance and safety, or in financial terms, risk.
When an investor builds an investment portfolio, they often have one goal in mind: to maximize returns. This means they potentially have a one-track mind and aren’t really taking into consideration how their portfolio would perform under certain (potentially bad) circumstances. For example, what would happen if the Chinese market collapsed, inflation rose or we went through another recession? Once you get the results, you need to compare the results against long-term return expectations and figure out how to either accept or mitigate those stress points. At Twelve Points, we feel it’s important to do a portfolio stress test for each and every client. This enables us to set their expectations and plan for their financial futures.
As this 2014 Forbes article points out, while we can’t control the market, we can control the following 3 things:
- Asset Allocation. How diverse are your investments, how are you allocating your assets between stocks and bonds? One way to figure out if you have the right balance of stocks and bonds in your portfolio is by assessing the risk under different scenarios, both historical (e.g., Black Monday, the Gulf War) and hypothetical (e.g., a recession, inflation), and seeing if you can keep that balance as is long-term no matter what the market does.
- Costs. You want to make sure your portfolio’s expenses are at a minimum by, for example, investing in some low cost funds.
- Tax Efficiency. The ultimate goal is to mitigate taxes in order to save more for retirement sooner. This can be done by taking full advantage of retirement accounts and paying attention to asset location.
How you consider risk as an investor is an important factor in managing your portfolio. If you’re too conservative, you may be missing out on making returns. If you only focus on recent events, you may be leaving something important out of the equation. You need to figure out a balance of risk and return that you’re comfortable with that also produces results. Depending on where you are in your life, a portfolio stress test may dramatically affect your investment strategy — or it may have barely any effect at all. Your financial advisor can help you determine your target risk profile, which is based on your investment goals, time horizon, risk preference and market views.
Our FREE portfolio stress test runs your portfolio through over 60 scenarios, so different aspects of your portfolio may be exposed under different circumstances. Once you take it online, we will follow up with you to walk you through the potential risks to your portfolio and recommend a plan of action to protect against them. Feel free to share this information with your friends and family. If you have questions, please contact us at (978) 318-9500 or email Terri@TwelvePointsWealth.com.