How to stress-test your financial plan

Are you Financially Resilient?

One year into the Fed's rate tightening cycle and we're starting to see some cracks emerge in both Main Street and Wall Street, as there have been some material events that have clients second-guessing investment decisions and worrying about downside risk. However, it is during times of some normalcy that one should be stress-testing their own investment portfolio and getting a better feel of their "financial resilience"...NOT during times of panic or crisis.

Stress-testing a portfolio is simply done by utilizing a clients' financial plan to look back at historical periods where there were significant bear markets to see how the portfolio would have performed over specific market cycles. Unfortunately, the use of past performance is not perfect, as it does not address bad timing, as well as the infamous Black Swan.

Metaphorically speaking, a black swan event describes an occurrence that comes as a major surprise, has a significant negative financial effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.

How bear market returns impact your portfolio

When analyzing a client's financial portfolio, it is fairly simple to back-test your allocation to see how it would have fared during specific market periods. Our investment goal with clients is less about market outperformance on the way up and more about protecting portfolios on the way down:

• Limiting losses keeps assets at a reasonable level for clients to feel comfortable and stay invested.
• Keeping more assets intact means that clients need a lower return to get back to even.

Generally, bear markets have only been associated with stock portfolios, so most investors only thought equities could be volatile. However, there can be prolonged periods of losses on bond portfolios that have an equally significant impact on "conservative" portfolios as well. It is important to make sure that ALL asset classes are not only stress-tested during their worst market cycles, but also during periods when we don't know what or when something bad will happen.

Bad timing is just bad luck

Looking at historical market returns, the longer the time frame, the lower the volatility as you smooth out the largest market moving days. There are numerous case studies on the vast differences in market performance by pulling out the best and worst days; but what happens if you don't have the luxury of hindsight or a choice on when you need to draw income to meet goals? This is bad timing.

The foundation of a client's plan focuses on major goals such as college & retirement. These usually come with a specific date in a clients' life, however, the problem is that this date might not be the best time from a market perspective.

When building the financial plan, we purposely "predict" two consecutive years of negative investment returns the year following retirement. We literally want clients to be able to see what their portfolio will look like so there are few surprises. There is nothing worse than finally leaving the stress of your job only to worry about the stress on your portfolio.

The Black Swan event

Metaphorically speaking, a black swan event describes an occurrence that comes as a major surprise, has a significant negative financial effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The problem with predicting these occurrences is that it can come from anywhere at anytime and not be directly tied to a financial event (a global pandemic, as well as an act of war come to mind).

Preparing for an end-of-world event is tough because it only happens once and we have found that clients who want to hoard gold bars are usually left holding assets that no one wants or needs. There really is no way to predict these, but having a liquidity strategy where emergency cash is on hand for a prolonged period is usually the best plan.

Staying nimble & resilient is the key to financial success

Although investing in anything outside of liquid cash requires a long-term time horizon, that doesn't mean you should be locked into anything that you can't reallocate when circumstances change. This is being financially nimble.

Being financially resilient means making sure you have ample cash on hand to weather whatever comes your way. This is usually not what you think will happen, nor when you think it will happen. Bad timing can easily derail your plan.

Fortunately there are numerous regulations that oversee our financial systems. Unfortunately, these may not immediately trickle down to your investments. Running your own "stress-test" on your portfolio is the first step to making sure you can sleep at night regardless of what's lurking around the corner.

-Jason

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