Stress Testing Your Portfolio
Courtesy of Michael Batnick, The Irrelevant Investor
I recently received an email about a piece of software that would allow us to stress test our portfolios. Some of the scenarios included:
- What if interest rates rise back to historical levels or above, with 10-year treasury rates at 5%, as a result of renewed growth in the US economy?
- What if the S&P has a strong correction and falls 20% over a short timeframe?
- What if 10 year treasury rates rise 100 basis points as interest rates normalize?
- What if a recovery in global economic growth drives demand for commodities and higher inflation?
- What if economic growth pushes inflation up to the Fed’s target levels in the US?
This sounds appealing, why wouldn’t you want to know how your portfolio would respond in different environments? The better prepared you are, the more likely you are to remain calm when stress arrives. But there are a few drawbacks to going through this type of exercise:
- These scenarios are front and center on every investor’s mind. Risk, by definition, is hard to identify in advance.
- What if one of the scenarios does happen, but it’s not for the reason we assume. For example, what if the 10-year rises to 5%, but not as a result of growth?
- What if the 10-year does rise to 5%, but it happens gradually over the next few years? And what if it happens in three months?
- What if we experience a combination of these things? How many simulations should we run? And should we change anything based on the results?
- What if your portfolio doesn’t respond the way the model predicts it will?
Stress testing your portfolio might sound like a good idea, but it can give investors a false sense of security and expose them to the biggest risk of all, what if your portfolio does respond the way the model predicts, but you’ve overestimated your true risk tolerance? I’ve said this before, but thinking in percentage terms is a bad idea. It’s easy to say, “I can handle a 25% decline in my portfolio, I’m a grown up.” Think in dollar terms. If you have one million dollars, a 25% decline is $250,000!
There is no right or wrong number, that dollar amount is going to be different for everybody. This is the most important thing; Never put yourself in a position of doing irreversible damage. If that means foregoing possible gains, fine. The opportunity cost is meaningless if you can’t stomach the drawdowns those returns require in the first place.
