portfolio stress testing

In short

A friend of mine once told me she felt safe because her accounts had always gone up. Then one bad year taught her what a portfolio can actually do. A stress test is a way to ask that hard question while nothing is at stake. It takes your holdings and runs them through a rough patch, past or imagined, so you can see the damage on paper first. Pick one scenario, such as a drop in stocks like the one in 2008, and apply it to each piece of your portfolio. Add up the dollar loss and compare it to what you could stand to lose without selling in a panic. If the number scares you, that is useful news, not bad news. Change the mix on a calm day, not in the middle of the storm.

The whole of it

What it is

I once watched an old farmer walk his fence line every spring, pushing on each post with his boot. He was not worried. He just wanted to know which ones would give before the cattle did. A portfolio stress test works much the same way. You are leaning on your own investments to see where they bend.

You have probably heard about checking returns, which tells you how things went. A stress test looks the other way. It asks how things could go wrong and how much it would cost. It does not predict the future. Nobody can, and anyone who says otherwise is selling something. What it gives you is a picture of your own exposure, which is the amount of your money tied up in any one risk.

Banks do this on a grand scale. The Federal Reserve runs yearly stress tests on large banks to see whether they could survive a severe downturn. You can read about that on the Federal Reserve Board website. Yours will be smaller and simpler, and it is no less worth doing. You are the one who has to live with the outcome.

How it works

A woman I know keeps a notebook where she writes down what she would do if the car broke down, the roof leaked, and a paycheck stopped, all in one month. She calls it her rainy day rehearsal. A stress test is that same habit for your investments, and it comes down to three steps.

First, choose a scenario. You can borrow one from history. Stocks fell sharply in 2008 and again in early 2020, and bonds had a rough stretch in 2022 when interest rates climbed fast. Or you can invent one, such as stocks falling 30 percent while bonds fall 10 percent. Past events are handy because they really happened, which keeps the exercise honest.

Second, apply the scenario to each holding. If a fund holds only stocks and stocks fall 30 percent, the fund is assumed to fall about 30 percent. A fund that holds a mix is assumed to fall by a smaller amount. Many fund companies publish how a fund did in past downturns, and the fund prospectus, the official document that describes what a fund owns, also lists what the fund holds.

Third, add it up. Total the loss in dollars and then as a share of the whole. Then ask the question that matters most. Could you ride this out? That depends on your time horizon, your income, and your nerves. A person ten years from retirement has less room to wait for a recovery than a person thirty years away.

The numbers, and where to find yours

You have probably wondered where to dig up the figures you need. The good news is that most of them are sitting in your own statements. Your brokerage or retirement plan lists each holding and its dollar value. Start there. Add them up for your total.

Next, find out what each holding is made of. The fund prospectus or the fund company website lists the share in stocks, bonds, and cash. Note any big single positions too, such as a lot of company stock, since one name can sink a plan.

For history, the index publisher S&P Dow Jones Indices posts yearly returns for the S&P 500, including the steep drop in 2008. The exact size of a drop depends on the dates chosen, such as a calendar year or a high point to a low point. Fund companies also post how their funds did in past downturns. A scenario works best when it matches how the money is actually invested.

If you hold retirement accounts, the annual contribution limits and age rules are set by law and change from year to time. The current employee deferral limit for a 401(k) is the current figure, which the official source publishes each year, and the IRS publishes it. That figure matters here only because it tells you how much new money you can add to rebuild after a loss.

A worked example

Let me tell you about a man named Walter, age 58, who keeps $400,000 in a retirement account. He holds $280,000 in stock funds, $100,000 in bond funds, and $20,000 in cash. He wants to retire in seven years.

Walter picks a harsh scenario. Stocks fall 35 percent, bonds fall 8 percent, and cash holds its value.

For the stocks, $280,000 times 35 percent is $98,000 lost. For the bonds, $100,000 times 8 percent is $8,000 lost. The cash loses $0. His total loss is $98,000 plus $8,000, which is $106,000.

His account would drop from $400,000 to $294,000. That is a fall of $106,000, or 26.5 percent of the whole, since $106,000 divided by $400,000 is 0.265.

Now Walter asks the honest question. He has seven years until retirement. A drop of $106,000 would be hard to stomach, and it might set his plans back. He decides he would sleep better with less in stocks. Suppose he moves $60,000 from stocks to bonds. Then he holds $220,000 in stocks and $160,000 in bonds.

He runs the test again. Stocks: $220,000 times 35 percent is $77,000. Bonds: $160,000 times 8 percent is $12,800. Cash is still $0. The total loss is $77,000 plus $12,800, which is $89,800. That is 22.45 percent of $400,000.

The loss shrank by $16,200. It is still a real hit. Walter did not remove the risk. He measured it and made a choice with his eyes open. I will not tell him which mix is right. That is his call, and your call is yours.

Where it goes wrong

I once knew a fellow who ran one scenario, saw a small number, and decided he was bulletproof. He was not. A stress test is only as good as the story you feed it.

One trap is testing a mild scenario. If you only test a drop that would barely sting, you learn nothing. Try one that makes you wince.

Another trap is forgetting that things move together. In a real panic, stocks and bonds can fall at once, as they did in 2022. Assuming that bonds will always cushion stocks can leave you caught short.

A third trap is ignoring what you hold inside your funds. Two funds with different names may own many of the same companies. Then your spread is thinner than it looks.

Then there is the human side. A number on paper is not the same as watching your balance fall day after day. People often say they can take a 30 percent loss. Then it happens, and they sell at the bottom. Be honest with yourself about your nerves.

Last, a stress test looks at one moment. Your life changes. Run it again after a raise, a move, a new job, or a birthday that brings retirement closer.

Questions to answer before you leave this page

What is the total dollar value of everything you hold, and how much of it sits in stocks, bonds, and cash? Which scenario would truly worry you, and how many dollars would you lose if it came true? Could you cover your bills for a year or more without selling anything at a low? Do you hold a large amount of one company or one fund that might sway the whole result? How many years until you need this money, and what happens to your plans if a loss like that arrives next spring? Would you stay calm, or would you reach for the sell button? And when will you run this test again?