STRESS TESTING YOUR PORTFOLIO

Posted on August 8, 2012


So you have done the right thing- you have saved diligently, spent responsibly, invested in a disciplined manner, diversified your holdings, did not panic during the wild swings in the markets and did not chase the fad du jour. Perhaps you have even put a financial plan in place. Still, you are not quite at peace about your financial security. The dust never seems to settle in the financial markets and the low interest rate environment prevents you from earning the return you deserve on your savings. The risks are very real: turmoil in Europe, geopolitical tensions, banking scandals, impeding fiscal cliff, natural and man-made disasters just to name a few. Add to this inflation risk, credit risk, currency risk, interest rate risk, default risk inherent in the markets and the picture becomes more uncertain than ever. Whether you are already retired or approaching retirement, you now have less time to sit out the market storms. How do you know whether the next “black swan” will merely cause “paper pain” or devastate your retirement plan?

Having invested our clients’ retirement savings for over a decade, we know that investing is as much about maintaining peace of mind, as it is about getting a decent return on your money. We also know that clients do not invest for the sake of investing. They invest because they want to reach their goals such as retirement, paying for their children’s education, maintaining their living standard and so on. Your portfolio should reflect these goals. Taking any more (or any less risk) than you can afford can be hazardous to your financial health. However, just having the portfolio that reflects your goals is not enough for peace of mind. You need to know whether your portfolio can withstand the commotions of the market. What if there was a way to estimate how your portfolio will react to the next turbulent patch in the market and whether this turbulence will affect your progress towards your goals? Whether you are in the accumulation stage (adding to your portfolio) or in the distribution stage, (using the money to pay for your living expenses), the sequence of returns has a significant effect on your portfolio value. Seven lean years followed by seven fat years have a very different effect on the value of your portfolio than if they were to come in the reverse order. How do you account for all possible scenarios? How does one plan for the unpredictable?

Institutional investors such as banks and endowments have been using a process called “stress testing”. This is an exercise where computer software is used to model several thousands possible scenarios to come up with the most likely case and the worst possible case by plugging different sequences of investment return into calculations. Knowing what the worst-case scenario may hold and what kind of the effect it will have on the portfolio and on the ability to meet future obligations is an invaluable planning tool. Such a tool is now available to our clients via the financial planning software we use. First by learning what your specific plans and goals are for the future and then using our Retirement Analysis and the Monte Carlo software built into it, we are able to stress-test the portfolio and see how much of a loss your portfolio can tolerate and still provide enough income for you to live the lifestyle you want. Knowing your number may help you stay at ease during the next market turmoil and on track to your goals. Prudent, appropriate strategies and peace of mind for the investor is what the financial planning is all about. If you would like to learn more about stress-testing your portfolio, or have a question please contact us by filling out a form to your right.

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