In the Puyallup Valley, periodic drills help residents and emergency responders simulate a volcanic mud flow pouring down from Mount Rainier. Along the Washington coast, tsunami drills are practiced. And in schools, fire and earthquake drills occur regularly.
These practices prepare people to respond to generally low-likelihood events. Ideally, a little planning and knowing how to react can reduce stress during chaotic times.
One area of our lives where occasional chaos is more likely usually goes without much preparation. Most people haven’t participated in a drill to simulate possible outcomes — and their response — if investment markets turn significantly downward.
Investment declines don’t usually take place in a brief moment. They tend to unravel more slowly than suddenly. They can feed upon themselves in a downward spiral with no end in sight. However, amid the spiral it is important to understand long-term probabilities and not place too much emphasis on recent occurrences, knowing all along that this is hard to do.
Your response to a declining market must come in relation to your personal risk tolerance, your investment time horizon and your highest priority goals — the real purpose of your money.
If you can simulate disruptive events to your investment portfolio you will be more prepared to evaluate your options and position your investments to seize opportunity when it returns.
PORTFOLIO STRESS TEST
Most people have general sense of downside investment risk given past experience. But few people hold the same investments today that they did during the last crisis, so it’s a worthwhile exercise to examine how your current investments may respond to adverse circumstances.
For this purpose, I use an investment technology platform that simulates historic returns and volatility data to identify performance that a portfolio can reasonably be expected to achieve under various circumstances.
This information is useful for creating a market upheaval drill. Here’s an example of how this works using a globally balanced investment strategy. This hypothetical portfolio of broad market index funds holds 60 percent stocks (40 percent U.S., 20 percent foreign) and 40 percent bonds (32 percent U.S., 8 percent foreign).
The modeling indicates that this portfolio has a 95 percent probability over a six-month period of delivering returns between positive 21 percent and negative 13 percent. But actual market events deviate to the extremes more often than general statistics might suggest. Therefore, the 13 percent downside expectation is not exactly a floor, especially if declines persist for longer than six months.
If this same 60 percent stocks, 40 percent bonds investment portfolio had been held from October 15, 2007, through March 2, 2009, this portfolio would have declined 37.9 percent. Yes, down more than one third even for a broadly diversified portfolio.
Certainly, conservative portfolios will respond differently than aggressive portfolios depending on the various factors that shake up global markets. Knowing how your specific investment mix could be affected is an important part of this drill.
If you don’t have access to sophisticated tools to project returns and identify downside risk, you can at least look at each of your investment holdings to examine how they fared in past bear markets. Go back to the 2007 to 2009 period to see how your stock holdings fared. (Morningstar.com is a good place to do this research.) Look back to last year from May to September to see what a rough period for bonds looks like. This exercise might help you identify individual holdings that are more risky than the stock or bond markets themselves.
MANAGE RISK, DON’T AVOID IT
Certainly, if you experienced the 2008-09 declines (as well as the 2000-02 tech wreck), you’ll have an educated response to the next market upheaval — whenever it happens. What’s most important to remind yourself is that investing at the point of maximum anxiety is also the point of maximum opportunity. March 2009 would have been an exceptional time to increase the stock market weight of your investment portfolio.
With investment markets trading at all-time highs and both stocks and bonds moving into expensive territory, now might be a good time to test downside risk of your investments. When declines eventually return — and this is not a warning that it is imminent — how will you respond? Should you preemptively rebalance your investments to reduce your most volatile holdings?
If you reduce risk, are you prepared to step back in later to buy stocks on sale, knowing the sale could continue to get better before prices go back up?
It’s important to examine the possible outcomes of adverse markets on your financial plan and envision how you would feel as this occurs. You may find that the downside potential of your holdings is acceptable in exchange for the opportunity to earn compelling upside gains. You may also realize the risk is more than you and your financial plan can absorb.