What is a Portfolio Stress Test and Why It’s Important

Think back to the 2008 financial crisis, an event highlighting just how vulnerable financial institutions were to market crashes and other economic downturns at the time. In response and to help minimize future bank failures, the government began requiring large banks to conduct annual stress tests: detailed analyses determining whether or not banks have enough capital to withstand another crisis.

Now, consider your own investment portfolio. While you may be on track to reach your goals, you should know just how vulnerable your funds are to another prolonged economic downturn and the pressure this could place on your returns—especially true if you’re nearing retirement and lack the time necessary to ride out any adverse market conditions.

This is precisely where a portfolio stress test comes into play and the very topic we’ll cover in this post.

What is portfolio stress testing?

A stress test is a risk-management tool that quantifies how well (or poorly) your portfolio might perform during an unexpected economic or market event; this involves constructing several “what-if” scenarios based on real-life (and hypothetical) macroeconomic/geopolitical uncertainties, identifying which parts of your portfolio are exposed in each one. Such uncertainties could include anything from the 2008 financial crisis, another pandemic like COVID-19, a tech bubble or significant dip in the S&P 500, increasing unemployment, interest rate hikes, inflation spikes, rapidly rising healthcare costs, or even a foreign economic slowdown. Various assets—including stocks, bonds, exchange-traded funds (ETFs), mutual funds, and options—can accompany stress tests.

Portfolio stress test advantages

The biggest benefit of conducting a stress test is that it helps identify potential risks within your portfolio, giving you the ability to make any necessary adjustments upfront to mitigate potential peril in the future. One such risk is perhaps having too much exposure to stocks within your asset mix or overexposure to specific industry sectors (e.g., technology or energy equities).

A well-conducted portfolio stress test also offers realistic and insightful perspective regarding how much (or how little) progress you’re making toward your financial goals. For example, you may want to learn if you’ll run out of money in retirement, have enough money to retire within the next 5 to 10 years, or even have the ability to maximize the inheritance you’ll leave for heirs. Whatever your financial objectives, stress testing gives you the means to plan for worst-case scenarios beyond just making broad assumptions (or simply crossing your fingers) that your portfolio is well-equipped to withstand significant market downturns.

Risk tolerance and stress tests

Your risk tolerance (ability and willingness to tolerate large swings in investment value) also plays a role in portfolio stress testing. For example, a stress test might determine you need a 7% return to increase the chance you’ll reach your goals and thus dictate you feel out how comfortable you are with additional risk. While you can also adjust other levers (such as how much you save and spend), how you address these shortcomings is a matter of personal preference—with your strategy often depending on how much risk you’re willing to tolerate.

To assess your risk tolerance, your financial advisor will typically furnish a questionnaire that asks several questions about various market scenarios (e.g., “What action (if any) would you take if the stock market fell by 15% over six months?”). Your responses then help determine how to best allocate your money based on how comfortable you are with risk. The higher your tolerance, the more likely your portfolio will include riskier investments such as stocks. A lower risk tolerance, meanwhile, could fill your portfolio with more stable investments such as bonds or certificates of deposit (CDs): all while considering your financial goals and time horizon (the period of time between when you make the investment and actually need that same money).

Portfolio stress test considerations

When conducting a stress test, you’ll need to understand a few key factors to feel more confident that your plan will hold up through the most challenging of times—and that these assessments are only effective if conducted at regular intervals rather than as a one-time event. Specific factors include…

Saving & spending

You can modify your saving and spending habits to help reach your goals, especially when test results indicate a high probability you’ll fall short of your objectives. Knowing how much you’re saving and spending monthly (or annually)—rather than just guessing—is critical, as you may need to determine if you can either generate additional income or cut expenses to help make up for the funding gap (especially if you aren’t comfortable taking on additional risk or otherwise adjusting your goals).

Growth rate

If your financial advisor uses super-aggressive growth rates for your projections, you may want to ask him/her to pump the brakes. Why? Because unrealistic numbers—even those off by just a few percentage points—can significantly inflate the value of your projected assets and thus give you false assurances that your investments will withstand future market downturns. A conservative growth assumption is therefore recommended to give you a more realistic picture. While somewhere around 5% is a standard growth rate, it’s important to not only learn which exact one your financial advisor is using but also find out why.

Inflation

Inflation is a rise in the average cost of goods and services over time. While not all inflation is bad (perhaps contrary to popular belief), this phenomenon can adversely impact your retirement in many ways if not adequately accounted for.

For example, let’s assume you plan to retire in twenty years and are saving $500 per month ($120,000 in total) while earning an average annual return of 7% (in line with historical trends). In this scenario, you’d end up with $261,982.70. Assuming a 2.5% inflation rate—common, based on our research—the future value of your $261,982 is roughly $159,880, stifling your ability to buy as many goods and services as you do today. Your financial advisor must therefore account for inflation in any projections.

In sum: portfolio stress tests

While it’s impossible to predict the future, recessions and other events that adversely impact financial markets are fairly inevitable and thus likely to affect your own investment value as well. Thankfully, a portfolio stress test can help put you in a better position by ensuring you aren’t over-exposed to such risks moving forward.

Concerned you may have too much risk in your portfolio? Seek out a complimentary portfolio review and risk assessment today from one of our CFP® professionals to enjoy some peace of mind.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.