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Prep Your Portfolio for Disaster With a Stress Test

Stocks in this article: STI

BOSTON ( MainStreet) -- In the aftermath of the financial crisis, banks had to perform "stress tests" of their viability and ability to withstand economic shocks.

The same concept has long been a part of professional portfolio reviews, but it's a process most people either don't fully understand or simply neglect.

Can your investment choices take a shock to the system? A stress test may help insulate you from shock, just as tests from a doctor can set you on the right path with medication, diet and exercise.

How would your portfolio of investments weather a shock? Is it structured to fend off the asset-eroding potential of triggers such as so-called Black Swan events, Black Monday-level market implosions, interest and inflation rate swings, war or an oil supply disruption? Unchecked, international matters -- sovereign debt, an Asian currency crisis or Russian devaluation -- can also take a toll.

"Unfortunately most people don't truly have a plan when they invest," says Mickey Cargile, CFP, managing partner of Cargile Investments. "The first thing they need to do is decide how much of their money they want in safe investments and how much they want in risk. Part of a stress test is to understand how both parts work together and to also monitor the performance and make sure you are getting at least a fair return for the risk you are taking."

Cargile says investors can start by looking at their "risk" assets, money invested in the stock market, and compare the return on that money to those of an index such as the S&P 500.

"If your portfolio is down because the market is down, usually that's OK," he says. "But if you are down and the market is higher, you know that you are taking more risk than you are compensated for and need to make adjustments."

Cargile says this knowledge, combined with a more holistic look at all assets, shouldn't be a daunting prospect.

"Setting up your asset allocation between risk and nonrisk investments -- in other words, fixed income and equities -- and then rebalancing back toward that target, is not something that is really turning your portfolio upside down. It is just a mechanical way you can take advantage of the swings in the markets and the different investment climates. There is a difference between sticking to a plan versus putting your head in the sand. I think a lot of investors have that 'head-in-the-sand' philosophy. When the prices go down, they just don't look at their statements -- rather capitalize on it, rebalance, buy stocks at lower prices and then when they run up, start taking profits. Rebalancing back to a target forces you to take profits when the market goes up and it frees you to buy when the market goes down. That's why it works."

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