How exactly do you stress-test your financial plan?

If you’ve been investing for some time, you likely have a plan ready. Of course, these plans will vary depending on your specific goals, age, and risk tolerance. But the primary consideration is that some sort of achievable goal, along with a plan on how to reach that goal, is common to most investors.

Along with this comes a fatal flaw that is often noticed: these plans are made in a vacuum. You might think, if I keep earning my current salary, put 10% into savings, and invest another 25%, everything will be fine. Unfortunately, nothing happens in a vacuum – at least in the investing world.

The truth is that the circumstances in which you put your plan in place will certainly change. Income can fluctuate (either predictably or unexpectedly), interest rates change, Inflation goes up or down, economies suffer recessions, and industries crash.

This means that our immediate cash needs and the risks associated with certain investments can fluctuate greatly as well. The way it affects our long-term financial plan is vital.

None of us can predict how the future will develop. However, we can An approximation of what would happen to our business portfolio if some of these initial factors were to change. The basic idea isn’t too complicated: If your primary source of income drops sharply, will your limited savings require you to liquidate long-term investments to generate short-term cash flow, thus eliminating your entire retirement plan?

These are the events we want to avoid – and the stress test in our financial plan helps us do just that.

In practice, this process requires a huge amount of knowledge and experience. Most investors turn to financial advisors for help in such a task. Whether you’re looking to do it yourself, or plan to turn to a trusted advisor, the following will provide you with a head start either way.

Stress Test Your Portfolio: Considerations

The first and most important aspect of stress testing is starting with a budget. Calculating your budget will allow you to forecast cash needs over time.

Understanding your cash needs—your income, financial goals, and lifestyle—allows you to learn about the most important aspect of successfully managing a financial plan over time: your goal is not just to grow your assets; It’s about liquidity management.

Life happens – and we all eventually experience unexpected monetary needs. The last thing you want to do in such a situation is liquidate a long-term investment to meet your short-term cash flow needs. Not only will this transform your long-term financial plan, but you will likely incur additional immediate expenses through capital gains taxes.

When most investors think about their financial plan, they think so long-term. Which is great – but everyone needs to prepare for a rainy day in the near future. The key to finding this balance between a long-term vision and the near future is liquidity management, which all begins with budgeting.

If your budget is not clearly defined, then you have already missed the stress test.

So, once you determine the budget and projected cash flows, the focus shifts to your portfolio. This is where things get a little tricky. Most portfolios are created using tools that only professional money managers can access. This is why it is always best to hire a financial advisor.

Above all, there are two basic concepts at play in your stress test: an asset estimate and an after-tax cash flow forecast. This is very similar to Strategies behind many large endowment fund managers – But only on a small scale.

In fact, this usually involves checking risk ratios to calculate expected returns and volatility modern portfolio theory. The clear goal is to maintain the lowest risk ratio for the highest expected value. A key component is maintaining a balance between risk and reward, and one of the ways this is done is through the Sharpe ratio.

Simply put, the Sharpe ratio adjusts the expected return of an investment based on its risk. Let’s say Jerome and Sarah are traveling from point A to point B. Jerome takes his car at an average of 45 miles per hour. Sarah takes her motorcycle, averaging 75 mph. Of course, Sarah got to point B first. But she – she also took much greater risks than Jerome – despite the fact that they both made it to the same destination.

Was the risk Sarah took worth the benefit of her early arrival? Of course, the level of risk you are willing to take will vary based on your unique situation, but that is the kind of insight that Sharpe’s ratio aims to illustrate.

Then, there are some stressors to throw into the mix. The main one should be the loss of the initial income. Many experts suggest having Three to six months of your salary It can be easily accessed as cash in a savings or brokerage account. Oftentimes, this simply isn’t enough. More conservative savers aim for a number closer to 12 months. Once again, we see how starting with a budget—to identify monthly expenses and manage short-term cash flow needs—plays a critical role.

For most people, the end goal of this whole process is to adequately prepare for your retirement – so that you can actually retire on time. For various reasons, the average retirement age continues to rise, especially for men And Entrepreneurs over 65. Make decision Continuing to work is one thing, but feeling obligated to keep the income flowing is another. Testing your portfolio stress will help you gain a better understanding of your readiness for life’s ups and downs – and hopefully help you sleep better at night.

Of course, the above steps are easy to understand in theory, but actually implement them more difficult. Building a budget, measuring risk, and assessing expected value are challenging tasks. While it is not necessarily impossible to work on your own, the above framework should – at least – be used as a model when choosing a financial advisor.

One way financial advisors test different scenarios – and their subsequent impact on portfolios – is through Monte Carlo simulations.

Monte Carlo simulation

Dwight Eisenhower once said, “Plan is nothing, planning is everything.” While the first part of this sentence may be too harsh, one has to agree that the actual planning is more important than the plan. Plans depend on circumstances, and circumstances change, but the ability to adapt—and build a plan—has value at all times.

Monte Carlo simulation works by making a financial plan and Simulate how it will pay Under various conditions the most important are changes in income, expenses, savings, life expectancy and expected returns from long-term investments.

Some of these factors are under your control – the income, expenses and expected returns due to the asset allocation depend to a large extent on you. However, market conditions such as inflation, investment horizon and many other factors do not. Therefore, in order to obtain a result, the Monte Carlo method assigns a random value to those uncertain factors. Then the simulation is run thousands of times to obtain a probability distribution.

If this sounds complicated, don’t worry. Even if you are a seasoned investor, this is a subject that requires professional experience in this field. The truth is that even if the software used to perform stress tests was available to the general public (which it isn’t), you would still have trouble deciphering and using the test results.

last thoughts

It is a daunting task to test a financial plan on your own. Leveraging the professionals is the most popular path here. However, you can do some prep work yourself to better understand the process and choose a financial advisor you trust. Most of this preparation will center around budgeting and making contingency plans for yourself – think of it as your introduction to a stress test.

Founder of Lakeview Capital

Tim Fries is one of the founders of Capital Protection Technologies, an investment firm focused on helping owners of industrial technology companies manage succession planning and transfer of ownership. He is also one of the founders of the financial education website code. Previously, Tim was a member of the global industrial solutions investment team at Baird Capital, a Chicago-based low- and mid-market private equity firm.

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