|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.|
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.
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.
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. Joe Mont. >To follow the writer on Twitter, go to http://twitter.com/josephmont.