Has Your Portfolio Been Stress Tested?
If you've been investing for some time, you've probably accumulated some wealth. Odds are, you also have a plan for continuing to invest and grow your wealth. Sometimes unforeseen economic events occur that can negatively affect your plans, however.
Stress testing helps you assess your portfolio's ability to handle scenarios that are often out of your control, such as industry crashes, inflation, recession, or changes in personal economic circumstances. It typically involves economic research, historical records, statistical data, and quantitative analysis. Discovering how your portfolio would react to potential adverse events can help you make wiser investment decisions.
Market volatility is a fact of life and can significantly affect a portfolio's value more than many investors realize. For example, if a portfolio declines in value by 25 percent, you'll require more than 25 percent to break even.
Many factors can affect portfolio values; in addition to macroeconomic events, geopolitical ones are also factors. A stress test will measure the impact on a portfolio by answering "what if" questions; for example, what if the oil industry crashes or what if the inflation rate hits 10 percent.
To be successful in investing over the long term, you must clearly define your budget. Otherwise, you'll have to pull money out of your investments to cover liquidity needs and will fail to build the wealth you desire.
Another aspect of a stress test is budget analysis. You develop a detailed budget, saving and investment plan, and long-term cash projections. Then you stress test for the possibility that you may lose income for a short time. Investors should typically have at least six months of expenses in a liquid investment, which is defined as one that can be turned into cash within a few days. Some conservative investors have up to 12 months of expenses in liquid assets.
Every investor's risk tolerance is different and often depends upon their age, financial goals, and personality. Generally, the more risk an investor is willing to take, the higher the potential return.
Stress-testing for risk uses modern portfolio theory, examining risk ratios to calculate risks and returns. Typically, the is the ratio used, which measures the amount of extra return you'll gain by being willing to accept additional risk. The ratio helps you compare potential investments by providing an adjusted rate of return based on the risk involved.
Another aspect of stress testing is examining your asset allocation. For example, a high percentage of stocks portfolio will decline significantly during a bear market. Also, specific sectors fare better than others during economic downturns. A portfolio that contains a significant percentage of technology stocks is riskier than one that holds health care and utility stocks, for example. Comparing a portfolio mix with major indices, such as the S&P 500 or the MSCI World Stock Index, is one way to ensure a resilient sector mix.
Consult an Expert
You should stress test your portfolio often to be sure it will handle potential economic and geopolitical crises without significant loss. Proper stress testing requires assistance from a wealth management firm. Wealth management firms have the necessary tools to measure the relationships between various events and your portfolio. They can test multiple asset classes and calculate ratios such as the Sharpe Ratio. They can also develop custom scenarios that are important to your own financial goals. Finally, they can recommend the optimal asset, sector, and liquidity mix.
Solas Wealth has the tools necessary to stress test your portfolio for the potential effects of economic and geopolitical crises. In fact, Solas Wealth focuses on downside protection in portfolio construction from the very beginning. Solas Wealth advisers use a rules-based approach to help decide where to invest during volatile times and automatically adjust your portfolio to market changes. We are an excellent resource for protecting your wealth from downside risk.
Schedule a conversation today for assistance in stress testing your portfolio and protecting yourself from unforeseen events.