Before a bridge is ever built, an analysis is performed by an engineer to determine how it will respond under stress. Stress tests are also performed for buildings, baby products, and numerous other consumer products we use every day.
If so much careful attention is dedicated to our safety in the design of the world around us, it stands to reason that we apply the same level of care when designing our investment portfolios. After all, our success in building our investment portfolios is essential to achieve some of the most important developments in our lifetime – our children’s education, our retirement, our legacy.
Unfortunately, too many investors build investment portfolios with one goal in mind – to maximize returns. In doing so, they fail to consider how their portfolio might perform when things go bad —when the next market correction occurs or inflation rises, for example. Some investors are risk averse and become overly focused on the risk. Without an accurate way to measure risk, they become too conservative.
In both examples, investors are employing risk-based investing (how they “feel” about risk) versus needs-based investing. The design of investment portfolios should start with a holistic analysis of your short and long-term needs. What range of return is acceptable to meet your life goals? A prudent answer to this question is rarely accomplished without performing comprehensive analysis that incorporates projected income sources, expenses, taxes, and inflation.
Once you have identified your required rate of return, you can then begin to model carefully-crafted portfolios, evaluate how they will react under stress, and determine how to address stress points. How you mitigate the stress points is largely a matter of personal preference -- a function of how much risk you are willing and able to bear based on your financial situation. It’s important to understand that risk and return are not separate — they are part of the same equation. Risk is really a cost that you pay to get the return that you need. If you are going to target a specific return, you must be willing to accept the associated risk or adjust your life goals accordingly.
If you want to employ smart, safety standards to help you succeed in the construction of your financial life, stress testing is a valuable tool to help you get there.
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