Take the Portfolio Stress Test
An extended period of stability, such as we’ve had, may encourage you to think your portfolio is bullet-proof. But cyclicality shows that when things feel most stable is often when they’re most vulnerable. And that’s the best time to conduct a portfolio stress test. So here are six tests to run now.

1. Figure out how much stock exposure you have – The most important component of a portfolio stress-test is determining how much stock exposure you have. It may sound banal, but investors don’t do this enough. Let’s say you discover that half your portfolio is in stocks. That’s often considered a “balanced” or “moderate” portfolio, but those terms don’t tell you much. The important things are what a big market decline will do to your portfolio, and how you’ll behave in response. A balanced portfolio would have declined by around 25% during the terrible market of 2008-early 2009. That’s because stocks themselves (half of a balanced portfolio) declined by around 50% during that period. If you owned some international stocks, you experienced a slightly greater decline.

2. Remember how you behaved in 2008-2009 – It’s true that the stock market has made all those 2008 and early 2009 losses back and much more over the past six years, but that’s only relevant if you didn’t sell your stocks in early 2009. So the next part of the stress test is to examine your past behavior. Did you hang on in 2008-2009? Were you so resilient that you actually added to stocks when they were down so much? Or did you sell when stocks had reached their nadir and were poised to rebound? If you sold on the way down or near the bottom during the last downturn, chances are you’ll respond badly again with the same exposure.

3. Figure out what kind of stock exposure you have – Besides knowing how much stock exposure you have, it’s also important to know what kind of stock exposure you have. For instance, how much international exposure do you have; what is your exposure to small-caps (the stocks of smaller companies)? International stocks can be more volatile. But asset managers with good records of evaluating future asset class performance, think international and emerging markets stocks are cheaper than U.S. stocks currently. Some think small-caps are priced to deliver lower future returns over the next 7-10 years. The point, however, is to figure out how much exposure you have to international stocks and small-cap stocks, and to understand the rationale behind the exposure.

4. Check your credit risk – Since you already know your bond exposure, once you figure out your stock exposure, it’s time to stress-test your bond holdings. (Cash is another asset class, but the assumption of this piece is that you’re using it only for short-term and emergency purposes. Bondholders face two risks — credit risk and interest rate risk. Credit risk is the likelihood that your bonds won’t pay you interest and principal on time or at all. Interest rate risk is the risk that interest rates and inflation will increase, thereby eroding the purchasing power of money invested in bonds.

5. Check your interest-rate risk -To understand your portfolio’s interest rate risk, study your bond funds’ “duration” numbers. Duration generally reflects how much the price of a bond fund will decline in the event of a 1% move up in rates. Bonds maturing relatively quickly will have lower duration. Keep a good intermediate bond fund as your workhorse, and let the manager decide if he or she wants to push a little longer or shorter on the duration spectrum.

6. Stress test your adviser too – If you don’t feel confident conducting a stress test yourself, have your investment adviser conduct one with you. Remember, your adviser’s function is to teach you about what you own and why you own it.

Submitted by Christine Olivieri Donahue