Give Your Retirement Portfolio a Stress Test
It can help you gauge how your nest egg might fare in a crisis
(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.
After the stress test, we then need to figure out whether to accept or mitigate those stress points.
(MORE: Why Risk Tolerance Is Overrated)
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.”
So how best to identify the stress points in your nest egg? And equally important, what’s the best way to address those stress points?
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.”
(Read Satchkov’s paper on the subject, The New Paradigm of Risk Management, and watch his related videos, Do Not Trust Risk Models! and Do Not Trust Risk Models! Part 2 with Barry Schachter.)
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.