August 24, 2018
What is a Portfolio Stress Test? And Why You Need One
Do you know how much your investment portfolio will drop in the next market downturn?
Neither do we. But there are tools available to help you evaluate your current investment portfolio and see how your current portfolio would have performed in all the major market meltdowns of the last 20 years.
For example, knowing that your investment portfolio (as it’s invested today) dropped 25% in the financial crisis when the market dropped 41%, is incredibly insightful information. It will help you understand the risk of your current portfolio and how much you’re likely to participate when the market drops in the next recession.
And it’s not hard to find this information out. Read on or click the link above to watch the video.
What is a Stress Test?
In 2008, the financial crisis brought the world’s banking and financial system to its knees. The government quickly stepped in to bail out the banks, and have since provided in excess of $4 trillion to banks to keep money flowing in the economy.
Regulations implemented since the financial crisis now require large banks in the U.S. to undergo annual stress tests to ensure that their balance sheets can handle the next crisis. The Fed runs a variety of tests – like high unemployment, a recession, or a housing crisis to see if each bank can stay afloat in a variety of predicaments.
Just like the banks, it’s very important to stress test your retirement portfolio. Could your nest egg survive a variety of stress tests – recessions and market downturns of 25% or more, higher taxes, living into your 90s, unexpected income needs because of illness, etc.?
How to Stress Test Your Portfolio
Several tools exist to help you stress test your portfolio. Financial planning software like MoneyGuidePro is capable of running a variety of “what if” scenarios for your retirement.
One great resource that is often overlooked is your 401(k) provider’s website. Most large retirement plan providers have excellent (and free!) tools to help you plan for retirement and change several assumptions like tax rates, inflation, longevity, etc. to stress-test your retirement.
I also like Fidelity’s Retirement Score Calculator, which allows you to run basic stress tests like living longer, lower investment growth, and higher spending rates in retirement.
Market Downturn Stress Test
Here at True North, one of the most important questions we want to help our clients answer is:
“What will happen to my portfolio in the next downturn?”
While no one can predict the future (despite what the TV talking heads would like you to believe), we use a tool called Kwanti to evaluate losses in the investment portfolio from previous market meltdowns.
The image above is a screenshot from Kwanti. It shows 5 separate downturns over the last 20 years:
- Asian Currency Crisis (1997)
- Russian Default/LTCM Debacle (1998)
- Tech Bubble Burst (2000-2001)
- World Trade Center Attack (2001)
- Subprime Crisis/Great Recession (2008-2009)
In each of these scenarios, the S&P 500 Index (blue bar) dropped from 10%-40%. The sample portfolio is shown in green and is a well-diversified portfolio that is invested about 60% in stocks.
What the stress test tool shows you is how much your portfolio would have dropped in each of these prior crises, shedding light on how you might expect your portfolio to behave in the future.
Did You Pass The Stress Test?
What if your retirement portfolio doesn’t pass a stress test? In some cases, that may mean altering your retirement date or your retirement lifestyle. Let’s face it…unlike the banks, you are not considered “too big to fail”, so you can’t expect a government bailout to fund your retirement if the economy, the markets, unexpected events, or you blow up your nest egg.
Even if you retire with several million dollars in assets, your portfolio likely won’t pass all stress tests, especially if you combine multiple stressors. Because no one’s assets are bulletproof, it’s very important to have a backup plan for the worst-case scenario.
If your assets are in a downward spiral, what other resources will you deploy to save your nest egg? Are you willing to reduce your income/lifestyle, sell your house, or get a reverse mortgage?
While these are all unpleasant situations to think about, deciding in advance what you will do in your own potential crisis situation will help you make sound choices today and in the future.
Put your current portfolio through a stress test!
“Planning is bringing the future into the present so that you can do something about it now.” – Alan Lakein
Guess what? It’s super easy too! If you are a True North client, give us a call at 503-387-6869. We’ll set up a screen-share, and in about 34 seconds and 3 clicks, you’ll see a market meltdown stress test on your portfolio! We’ll also email you a copy of your stress test report. Easy peasy! 🙂
Not a True North client? No problem! We can still run a stress test on your portfolio and send you our free, confidential stress test report. Send an email to Lara Fuchs – email@example.com – to get started.
It’s free, confidential, and secure.