) -- 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
. "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
"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."
Ernest Dawal, chief investment officer for private wealth management and institutional investment solutions at
Sun Trust Bank
, says the process isn't as easy to accomplish for do-it-yourself investors to accomplish as it is for a financial industry professional.
"If you have an existing portfolio and you want to stress test it , there aren't that many good
technological solutions available to just press a button and say, 'How would my portfolio do?'" he says. "The individual investor out there may not have it within their current means to do that, but if they have a professional money manager or asset manager they can take that portfolio and put it in a variety of complications that would allow them to see how it would have done in the context of historical events. We can give the client a better feel for what to expect if we saw, for example, a large drawdown of growth assets, a sell-off in the markets or a rising interest-rate environment."
"We do a lot of that analysis, in terms of strategy and tactical solutions, in our 'model' or recommended portfolios," he adds. "We don't always do it for the individual client portfolios because we don't have that push-button tool, but we are able to do that."
The methods for shock-testing portfolios vary from simple to complex.
"If it is just an interest-rate move, you can mathematically calculate the impact of on a fixed-income bond because there is a formula to do that and you can string those formulas along and figure out what that portfolio is going to do," Dawal says. "It is much harder to do that on the equities side. Who is to say what role interest rates might pay at a company? Interest rates rising or declining at one company might have a different impact than on another company. It is not a purely mathematical kind of problem."
For situations such as this, a variety of firms provide data and services that help financial advisers pick apart hypothetical performance in broad strokes or granular pieces.
"These tools are all good at doing various things," Dawal says. "Then the art, if you will, is putting them together. There are companies out there that profess to be able to take a portfolio and run it through some statistical analysis that will give you that type of simulation. What they are giving you is generally going to be asset categories, unless they have the specific return-and-risk parameters for every security in the portfolio."
Admittedly, even a thorough stress test offers no crystal ball.
A big question, Dawal says, is "how is the individual investor or the institutional investor going to react in the face of these stresses?" The assessment may offer effective help when talking to a client about could happen, "but it doesn't talk about what will happen ... It may also assume that you are rebalancing your portfolio, but we know that some clients aren't going to do that. So these tools are based on some simplifying assumptions that are not going to be applicable for every investor."
Nevertheless, understanding the impact of various scenarios does help craft better portfolios.
"We put portfolios together that we think would respond a certain way if an event unfolded," Dawal says. "Then we go back and test to see whether we were right. If they didn't perform the way we thought they would, then we dive into what didn't wok or what was different."
Prognostication is often the product of studying history and the many trends, cycles, bubbles and busts that have unfolded throughout the years.
"If you have a mutual fund portfolio, we can back-test it through a period," he says. "With a robust enough database you can isolate time periods that coincide with catastrophic events and see how a portfolio held up."
Dawal says such analysis can help gauge an investor's true risk tolerance.
"We can show them that 'This what happened on Black Monday' and what happened the 12 months after it," Dawal says. "This is a way to show the client that we are going to have these events. We don't know when an earthquake is going to strike Japan, New Zealand or the U.S., but we can tell them that, historically, this is what occurs when such events do happen. If you were in the midst of that, what could you have done, or should have done, within the context of your portfolio and maybe have fared better?"
"The closer you are to the point that you actually need to draw down this capital is when you have to be the most sensitive and aware of the impact of those sorts of events," he adds. "They can be catastrophic."
Rebalancing, reallocating asset classes and buying into specialized mutual funds and ETFs (engineered for specific financial outcomes or hedges) are among the potential corrective strategies when your portfolio isn't shock-resistant.
"If you can express to an adviser what your goals are over the next several years, they should be able to construct a portfolio that not only will show you, based on simulations, whether you can reach that goal," Dawal says. "These events happen. They are going to happen again. Clients have to be prepared for that. If you can show what different combinations of portfolios would do, I think that's a good thing."
-- Written by Joe Mont in Boston.
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