Many of us are familiar with the somewhat dreaded routine: climbing onto the treadmill at a clinic or our cardiologist’s office, having electrodes taped to our chests, and then undergoing a series of graduated exertions designed to measure our cardiovascular system’s ability to perform at greater and greater levels of effort. We don’t typically enjoy these outings, but the results are very important for maintaining our health and well-being. We need to know how our hearts perform under stress.
Similarly, engineers can testify to the importance of sensitivity and stress testing for materials and systems. Would you want to drive across a mile-long bridge, for example, if you didn’t know that the materials used to build that bridge had been tested and certified for their ability to hold up, not only in “normal” conditions, but also in bad weather, or under unusually heavy traffic loads, or when there was an especially strong tide?
Your financial plan can also be stress-tested. It can be very important, in fact, to have some idea of how your financial strategies and assumptions will perform under various scenarios–before you actually experience the scenarios!
Most financial plans have four important “pressure points”:
- Spending and saving
- Life expectancy
- Portfolio returns including portfolio volatility
For each of these factors, there are some matters that are in our control, and some that are not. With spending, for example, we can exert a fair amount of control over the percentage of our portfolio we spend during a year. We have less control, however, over certain types of expenses that may crop up during our life span–medical emergencies, for example. Fortunately, spending is the factor that most directly affects a financial plan, and also the one over which we have the most control. Inflation and life expectancy, however, are subject to very little individual control. Even Warren Buffett can’t control the worldwide trends in the cost of goods and services, and unless you were able to choose your parents, you have certain “built-in” life expectancy risks over which you can exert very little influence. Portfolio returns are the factor we most often focus on, and by exercising appropriate diversification as to asset classes and other investment characteristics, we can mitigate–though we certainly can’t control–the risks associated with the portfolio.
An informed and experienced investment advisor can assist you with “stress-testing” your financial plan by inputting various factors into a simulation that permits you to observe how your plan would perform in certain hypothetical scenarios. For example, let’s say you wanted to see how your plan would hold up if you increased your spending rate from an annual 5 percent of your portfolio to 6 percent. The simulation will show you the rate at which your assets would be depleted by the increase, allowing you to determine whether or for how long such an increase in spending could be sustained. Or, you might wish to see how your plan would hold up under various higher or lower inflation scenarios; a simulation can allow you to “stress-test” your plan for this possibility.
As the old saying goes, “Forewarned is forearmed.” Stress-testing your financial plan can help to fortify you against the unpleasant surprises that sometimes come our way. And contact us if this is a matter you would like to discuss further.