Give Your Investment Portfolio a Stress Test

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Getty ImagesFinancial advisers can use software to analyze how a portfolio will react to various scenarios.

When John Navin, a certified financial planner based in Nashville, Tennessee, meets a new client, the first thing he does is run his or her portfolio through a series of stress tests.

"We test the portfolio against 60 different circumstances that could happen in the economy," says Navin, who owns John Navin & Associates. "It can tell us exactly what the portfolio will do."

Navin and his team aren't alone. Financial advisers have software to provide detailed analyses about how a portfolio will react as different scenarios unfold in the world. Will China's slowdown turn into a recession or worse? Will the Federal Reserve raise rates half a point? Will the market turn down by 10 percent? Twenty percent? It's important to know how your portfolio will react to these scenarios.

As stocks have ridden an almost seven-year bull market, there hasn't been too much reason to know about potential disruptions to your returns. Even as Europe, particularly Greece, has struggled, the U.S. market has barely hiccuped.

But all good things do come to an end. And with slowdowns in the Chinese economy, the Fed considering interest rate hikes, weak oil prices and baby boomers leaving the workforce, there are concerns that the market could soon hit a speed bump. If it does, you should know how your retirement savings would move.

A stress test sets expectations. Testing your portfolio against a fall -- or rise -- based on real-world scenarios uncovers and highlights your risk if the worst happens. "Most people are taking on significant more downside risk than they think they are," says Michael Reese, a certified financial planner and owner of Centennial Wealth, an advisory firm based in Austin, Texas.

While most of us think we're comfortable with risk, it's often not true. Many investors pulled out altogether when the markets fell into turmoil in 2008. This proved to be the worst decision possible, because investors left the market as it hit bottom. Within three to four years, they would have regained their losses, but they weren't around to participate in the rally since the fall scared them off.

Stress testing shows what a 10 percent drop in the market will do to short-term gains, allowing you to understand what the loss may mean, Reese says. "If you see where you're at, and it's not a position you're comfortable with, then you need to revise the portfolio to take the risk off the table."

This is another reason why advisers run these scenarios. If clients see the market drop, their initial call will be to their money manager wondering what they should do. If advisers prepared them for such a scenario, then the drop is not as likely to draw that gut urge to react.

Test your whole portfolio, then test individual buckets. You want to test your whole portfolio because an event could affect parts of your portfolio differently. While a drop in energy prices could hurt the energy companies in your portfolio, it can also help many sectors that benefit from lower energy costs, for example. Yet, you would still want energy company exposure if prices rise again. You won't see the overall impact, unless you test it all at once.

Navin begins by testing a portfolio as one cohesive unit. Then he breaks it down, examining areas that his customers typically have money in, including cash and income-generating devices such as annuities, equities and bonds. By testing each individual bucket, he can discover the impact of fees.

This fee analysis can "factor in the management fees, cost of turnover and impact of taxes," Navin says. "You can really come back with a clear number."

It's important because over the long term, fees destroy a portfolio better than nearly any other factor, including short-term tumbles in the market.

Be careful how you react. Stress testing can serve many benefits, including providing data about your risk tolerance and setting clear expectations for your returns. But if you react wrongly to what you discover, then it could cause damage to your portfolio that you may never recover from.

For instance, someone in his or her 30s or early 40s probably still has one goal: Save as much as possible. Movements in the market shouldn't have any impact on this person's long-term strategy. "If you're well in your savings mode, then stress testing your portfolio is a fun exercise," Reese says. "But it's better to put your blinders on, [place] your money into an allocation, then letting it go."

On the other hand, if you're within 10 years or less of retirement, stress testing can dramatically change your strategy. Those thinking they wanted to retire shortly before the 2008 downturn hit had their plans cut short. The recession delayed retirement for many older Americans, and the number of 62- to 64-year-olds in the workforce actually increased during this period.

"When something happens that close to retirement, it can mess with your plans," Reese says. For near-retirees, stress testing can help this planning.

Don't test too often. Most financial advisers use two models to test their clients' portfolios. They judge them against historical numbers – like what would happen if another dot-com crash occurred – and they measure against hypothetical scenarios. Test both.

To get a comprehensive analysis, it's best to go through your adviser. But HiddenLevers also offers software that many advisers use to run the scenarios. There's a free account on its website, which will allow you to test different situations based on your portfolio allocation.

In terms of how often, Navin runs scenarios for clients once a year. Anything more, and you might be looking for a reason to make a change when there isn't any. Unfortunately, there's no scenario to test that mistake.

Ryan Derousseau is a journalist with nine years of experiencing writing about investing and leadership issues. His work has been read in Fortune, Money, CNNMoney and Fast Company, among other publications. You can find more from him on Twitter @ryanderous.
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