The Importance of Stress Testing Your Portfolio

Hi friends, we expect the market to be significantly more volatile this year than it has been over the past 2 years. That's why I want to discuss the importance of stress testing your portfolio, a crucial exercise to undertake before the next market decline. Doing so ensures that you're well-prepared for potential downturns and confident in your long-term investment strategy.

Historically, stocks have delivered incredible returns over the past 100 years. However, achieving those gains required investors to stay the course through many temporary declines. Stress testing your portfolio helps you understand how much it would have declined during past severe market downturns. This insight is critical because it allows you to gauge your own tolerance for temporary losses. If a significant decline would cause you to lose sleep or make emotionally driven investment decisions, then adjusting your financial plan and portfolio now may be the right move.

I prepared this chart showing the six times in my lifetime that the S&P 500 has declined by more than 20%. The average decline was 36%, and it took almost 3 years for the market to recover. These declines often come suddenly and without warning. They cannot be consistently predicted or avoided. However, if your portfolio is well structured and aligned with your risk tolerance, you can stay invested, ride out the storm, and even take advantage of lower prices by rebalancing.

Let's look at the most severe decline in recent history through the lens of a 70% stock, 30% bond portfolio. During the 2008 global financial crisis, the S&P 500 fell 55% at its lowest point. A 70/30 portfolio declined about 45% from its October 2007 peak to the March 9, 2009 bottom. It took about 3 and 1/2 years for the 70/30 portfolio to recover its previous value.

To fully benefit from the long-term returns of your portfolio, you would have needed to stay invested, tuning out fear-driven news cycles and those around you who were selling at the worst possible time. Even better, you could have rebalanced or added to your investments during the downturn. The reward for staying the course: that same 70/30 portfolio is now worth more than five times as much since March 2009.

If you believe that a 45% temporary loss would have led you to sell, then it's crucial to re-evaluate your current portfolio. History tells us that similar market losses will happen again in our lifetimes. Our clients have beautiful long-term financial plans designed to help them reach their life goals; however, selling during a severe decline can permanently derail that plan. That's why we strongly encourage you to stress test your portfolio now, before the next 20% plus market decline. Thank you, and I look forward to talking with you next Friday morning.