(This article appeared previously on MarketWatch.com.)
Before we start to rely on something, we often want to see how it will react under stress — whether it's a bridge, a baby stroller or a rocket.
Well, the same can be said about retirement portfolios.
We should be able to see how our portfolios will react under stress, says Daniel Satchkov, a chartered financial analyst and president of RiXtrema, a risk modeling and consulting firm that focuses on extreme financial-market events and has built a portfolio crash-testing service.
According to Satchkov, most — though not all — investors build retirement portfolios with one goal in mind: to maximize returns. And in doing so, they fail to consider how their portfolio might perform when things go bad, such as when inflation rises or emerging markets collapse. “Most of the time they ignore it,” he said.
To be fair, some investors are risk-averse rather than return-hungry. “Some people become overly focused on the risk and, without a way of measuring it accurately, they become overly conservative,” Satchkov said in an interview.
Still other investors might think about risk, but only in terms of recent events. “Right now, when people think about risk, they will think about ’08,” he said. “And all other scenarios are not really present in their thinking.”
In the real world, however, risk and return are not separate items; they are part of the same equation.
“Risk is not some separate thing you can dial up or dial down,” Satchkov said. “Risk is really a cost that you are paying to get the return that you need.”
Satchkov likes to use the car-evaluation process as the metaphor to help explain how it can be done.
“Choosing a car,” he said, “involves making trade-offs between performance (speed, handling, and the like) and safety. The goal is to get the appropriate balance between the two.”
Just as car crash tests have categories of frontal, side, rear and rollover, portfolio crash tests have categories of scenarios such as inflation, stock market crash, the tapering of the Federal Reserve’s qualitative easing program, recovery and the like.
Some of the risks are ongoing and permanent and some are transient and related to the news of the day, such as the crisis in Ukraine.
When crash-testing your portfolio, you should not select categories arbitrarily. Instead, determine which are the top 10 or 15 risks.
“The idea is to focus on an event that could hurt you,” Satchkov said. “Even if you think it’s not likely, that’s deceiving. If it can hurt you badly, more than you are willing to bear, then you should reconsider that exposure.”
In fact, to do this right, Satchkov said, you shouldn’t stress-test the events that seem most likely to you. Rather, best practice would have you run 10 to 15 stress tests without assigning probability and plausibility.
“There should be no prediction of specific events and certainly no timing prediction,” he said.
In creating his list of crash-test categories for his portfolio crash-test service, Satchkov works with risk-management experts who determine which events are plausible and probable. Satchkov also suggests that investors avoid thinking about the recent past or recent news when contemplating the sort of risks their portfolio might be exposed to.
Balancing Risk and Return
To understand the stress points in a retirement portfolio, the results of these stress tests must be presented side-by-side with the long-term return expectations.
“Long-term return must meet retirement goals and the investor must be willing to live with results of the crash tests that are required to get to that return over the long horizon,” he said. “Risk must be thought of as a cost, even though this cost is realized at uncertain times and the exact magnitude is uncertain.”
The ultimate goal is to show on one screen the downside, the base case and the upside for each investor’s portfolio. (See the chart below.)
So, for example, let’s say you had a portfolio with 50 percent invested in a security that tracked the S&P 500 index and 50 percent invested in security that tracked the U.S. investment-grade bond markets as defined by the Barclays U.S. Aggregate Index.
According to RiXtrema’s Portfolio Crash Test analysis, that portfolio has a long-term expected return of 4.6 percent a year. But if oil prices rise and there’s a supply shock, this portfolio is predicted to fall as much as 4.5 percent a year while those conditions persist. Given that, Satchkov said, you might consider reducing your stake in investments that don’t perform well when oil prices rise. Or, you might just keep an eye on oil prices and adjust your portfolio if and when necessary.
On the other hand, if there’s a global stock-market recovery, your portfolio would be expected to rise 12.5 percent a year.
The portfolio crash test “tells you what might happen [to your portfolio] under certain scenarios and it will tell you which parts of the portfolio are exposed to each scenario,” Satchkov said.
How to Relieve the Stress
How you mitigate the stress points is largely a matter of personal preference; it’s a function of how much risk you are willing and able to bear based on the financial situation.
“If losses cannot be tolerated, then long-term return will be decreased along with risk levels, which will mean that retirement goals must be reassessed,” Satchkov said. “Those positions that are contributing to the biggest crash-test losses should be sold in favor of the positions that gain in the same events. After any adjustment, the whole picture of crash tests and long-term return is presented again and iteration continues until the right balance is found.”
So how is all this possible? According to Satchkov, what’s happening with risk management today reminds him of what happened decades ago in the world of investing. “It used to be unthinkable for an investor to be able to buy and sell stocks,” said Satchkov. “You had to get a highly paid professional to do that for you.”
Well, the same is true with risk management. “The thing about risk management is that it was very expensive to calculate,” he said. “These calculations are very intense. But it’s become dirt cheap.”
So, what was once the domain of large institutional investors will soon be available to all investors. “Stress testing will soon be ubiquitous and will be the main way that financial professionals and retail investors discuss portfolios,” said Satchkov.
And that should help more investors manage their nest eggs.
Robert Powell is a MarketWatch retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.
This article is reprinted with permission from MarketWatch.com. © 2013 Dow, Jones & Co., Inc. All Rights Reserved.