By Jeff Headrick, Financial Planner
Are you ready for a portfolio stress test? Do you need to have one? These are great questions. As with just about everything in the world of investments, this is yet another topic that can be incredibly complex or really simple. It just depends how far down the rabbit hole you want to go.
As for me and my firm, we do perform portfolio stress tests on client portfolios. I don’t always refer to them as stress tests, but that’s what they are. It’s not too difficult to look into the past to see what a certain mix of stocks and bonds did or would have done. Likewise, it’s not too difficult to run projections as to what a certain mix of stocks and bonds might do in the future. Keep in mind, whenever you run projections that’s just what they are: projections. They end up being more like educated assumptions, but it’s better than just running blindfolded into the desert. It gives you a plan.
Learn From the Past
The biggest argument I can give for running portfolio stress tests, is that they give you a clearer picture. So many people I have met over the years fall into what’s called the recency trap. They assume that since their retirement account has been going up for the last five or six years consecutively, that will continue to happen. As we learned in 2002 and 2008, that’s not always the case.
Step 1. Get Help
The first step toward stress testing your portfolio should be to get help. Without a professional’s guidance, I do not think that the average or even the experienced investor is up to this task. Not only are financial advisors and financial planners trained using stress testing software, but they practice it every day. And it’s that practice that makes them very good at what they do. So step one is to get help. If you don’t have a financial planner and will like to learn more about hiring one, you may want to read article I wrote on the topic: The Financial Planning Revolution: A Beginner’s Guide to Working With a Financial Planner
Step 2. Stress Testing: Know the Basics
You need to know the basics about stress testing. I looked up the definition on Investopedia, and even they had a hard time defining it. But I did pull this from the definition:
Stress testing involves running computer simulations to identify hidden vulnerabilities in institutions and investment portfolios to evaluate how well they might weather adverse events and market conditions.
Articles like the one you’re reading are a good place to start. So you’re already ahead of the curve! You can also Google the term and perhaps watch some YouTube videos that demonstrate some software scenarios.
Step 3. Understand What the Software Can and Cannot Do
Please take a moment and watch the video above. Both of these gentlemen do a good job of describing what their software program does. I have utilized this software for a while now, and have found it very useful. This particular program, called Riskalyze, does a really respectable job of analyzing the risk in a portfolio, as well as providing stress testing capabilities. It does this by using historical return and volatility metrics to come up with ratings on almost a quarter of a million securities.
While this software does a wonderful job determining strengths and weaknesses regarding risk in a portfolio, it does not do detailed projections based on withdrawals in the future. At least not to an extent that I am overly impressed with. But the software itself is amazing. I use it to assess both tolerance for risk and how a certain mix of stocks and bonds might perform under a myriad of conditions.
But like all software, there is no panacea of solutions. You need to know what the software you are utilizing can and cannot do. Or, you need to make sure that your financial professional does, and can shed some light on that for you.
Step 4. Complete Your Inventory
Once you have a general idea about stress testing and how some of the software might work, it’s time to take your inventory. Most financial professionals will ask that you provide them recent statements of your current investment accounts. This would include your IRAs, your 401(k)s, and any other investment that you would like evaluated.
Having this information will provide your financial planner with the specific pieces of your current investment puzzle. Once he or she has this information, they will then enter all of your individual securities into the software to begin the process. This way your stress tests are uniquely designed to show strengths and weaknesses in your current portfolio investment structure.
Step 5. Look Back
Empire State Building: Photo by Emiliano Bar
I like to look back before I look forward. This gives me perspective. Once I have entered an individual’s specific securities into a particular software, the software will run multiple scenarios. It will show the client how a similar portfolio would have performed in the past, based on things that we know actually happened.
See the graphs below to understand how a certain mix* of securities may have performed during Financial Crisis of 2008 on a $750,000 401(k).
I am utilizing these particular funds for two reasons. One, they are used widely and well known. Two, I see a lot of pre-retirees that have a pronounced allocation to equities, with a splash of Lifecyle-Funds thrown in. Not a perfect recipe for great asset allocation, but it may look familiar to something you’ve seen before.
As you can see, based on the data we have today we can tell that if a similar crisis arose, the Vanguard, American Funds, Fidelity portfolio might experience similar losses.
But we can’t be too bearish. Once we have gained our perspective, we need to utilize our bullish vision and see how well a given portfolio may have performed during a period of prosperity as in the 2013 bull market.
Step 6. Perform Projections: Look Forward
Forward testing is where a financial advisor can add even more value. Usually, pre-retirement you are in what’s known as the accumulation phase of retirement planning. You are not only waiting on retirement, but you are adding money to your accounts regularly. This is fairly easy to do. But in retirement, you will not only cease adding money to your accounts on a regular basis, but you will begin taking money from them.
This is known as the distribution phase of retirement.
Below are three examples that display the withdrawal phase under three different scenarios. This is there hypothetical scenario:
John and Mary Smith are 59 years of age and wish to retire in six years at the age of 65. They have already run projections on both of their Social Security accounts which they will turn on at age 66. The total income per year from both Social Security accounts is $60,000. John has a pension that begins at age 65 that should be about $50,000 per year.
In addition to their pension and Social Security accounts, they have about $750,000 in a 401(k). The 401(k) is currently invested in the same mix of securities shown in the previous example (45% Vanguard US Growth ETF, 45% Growth Fund of America, and 10% Fidelity Freedom 2020).
They have requested to see multiple portfolio stress test scenarios showing how they're portfolio might perform from now until age 100. Keep in mind, for simplicity sake, they will not be making any more contributions, and their suggested withdrawal rate is 4.5% at retirement which we will adjust for inflation every year at 2.5%. In today’s dollars, 4.5% of $750,000 would be roughly $33,750 per year of income.
Stress Test 1. Average Sequence of Returns
Stress Test 2. Negative Sequence of Returns
Stress Test 3. Positive Sequence of Returns***
*** RetireUp provides several methods for modeling future returns and stress testing a plan. Each method creates a 100-year sequence of hypothetical returns which are applied to the plan. How Specific Sequences are Determined: Positive, Average and Negative. A typical plan will run 30-40 years, so only a subset of these 100 years will be used. For each plan, the software runs 100 year-by-year permutations of the simulated returns and determines which subsets of the entire sequence would generate the most optimal (Positive Sequence), least optimal (Negative Sequence) and median (Average Sequence) results for an individual plan.
Portfolio Stress Test Results
As you can see, and as Forest Gump would attest, “Life is like a box of chocolates. You never what you are going to get.” In example one during an average period of market volatility, the client’s savings does well.
However, in example two during a time of higher volatility, this same mix of assets could zero out. This may not be probable, but from a historical perspective it is possible.
Finally, example three shows that during a period of minimal volatility and positive growth, this same mix of investments may have even left a sizeable gift to the children, grandkids, and favorite charity.
If you are wondering what to do to smooth out some of this volatility, the answer is: ask your financial planner. They will be able to walk you through some steps to insulate you from those negative scenarios, while still striving to earn a competitive return.
Step 7. Build a Better Portfolio
I hope this gives you a better perspective as to the value of stress testing. Going into retirement without stress testing your portfolio under a myriad of conditions would be imprudent. Look at it like this. If you have a wife and a daughter like I do, what kind of test would you do on their car if it they said they were going to drive an hour away? Probably not much. But if they told you that they had decided to drive from Wilmington, North Carolina to San Diego, California, you would probably take the car into the local garage to get your top mechanic to go through the car bumper-to-bumper looking for potential problems.
Shouldn’t the same level of testing be done with your life savings?
It’s all about building a better portfolio. Stress testing is very helpful during the accumulation stages as mentioned above. But in the distribution stages of retirement it is even more critical. Armed with results of these tests, you can begin to construct a portfolio that may perform far better than it would have otherwise.
As always, good luck in your retirement planning and please do not hesitate to call us if we can be of assistance. (910)448-1450
Investopedia, Riskalyze, RetireUp Pro, Yahoo Finance, Vanguard, American Funds, Fidelity, Bob Drury CFP/CFA, Encyclopedia Britannica.
If we can help you in anyway, please let us know. We can be reached at (910)448-1450, or you can click here if you’d like to schedule an initial conversation.
Charts and graphs contained herein should not serve as the sole determining factor for making investment decisions. All hypothetical scenarios are for illustrative purposes only.
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