15 Jan 2016 Stress Testing
Market times like these can test our deepest resolve, especially when we are not prepared for the emotional impact of real declining wealth or learning the hard way that our ‘expertly designed portfolio’ sinks far more easily than we expected.
We don’t really know what we are made of or how we will handle adversity until we are tested to our breaking point. Good times hide a multitude of problems, not least among them, excessive risk. Risk-taking can be awfully fun when the wind and seas are at our back – like when stocks are going up real fast. But when those same winds and seas turn angrily against us, our confidence and adventurous spirit can turn to doubt and second-guessing just as quickly.
Sailors, pilots, and astronauts learned a long time ago that real-world stress-testing was costly – way too costly. So they devised a better approach, called simulation. In 2009, US Airways Captain “Sully” Sullenberger expertly ditched his Airbus A-320 jet in the Hudson River when both engines shut down on takeoff after ingesting a flock of birds. Capt. Sully, a former Airforce fighter pilot, had never ditched an aircraft in water before, but his hundreds of hours in flight simulators exposed him to all kinds of emergency situations in order to prepare and train him for a host of unlikely, but possible events. In fact, they prepared him so well that he not only expertly ditched his plane in the river, he did it calmly and professionally, informing air traffic controllers that he did not have sufficient altitude to land in New Jersey saying “we can’t do it, we’re going to be in the Hudson.” Ninety seconds before impact he ordered “brace for impact” and flight attendants instructed passengers how to do so. Stress-testing and training saved 155 passengers and crew on that day, January 15th.
The really interesting thing about stress testing is how much we benefit from it in virtually every aspect of our lives, but know so little about it. Highways and bridges are stress-tested for all kinds of loads and natural disasters. Cars, planes, trains, and ships are crashed, bent, twisted, and overloaded to their breaking points. Foods, drugs, and cosmetics are mixed in all kinds of combinations and quantities to determine their safety. Clothes are tested for flammability, batteries for overheating and explosiveness, networks and servers for their ability to stand up under severe loads, cyber attacks, and security. The list is virtually endless.
One of the most important areas of stress-testing that we know little of is conducted by the Federal Reserve regularly on the banking system. They test banks individually for credit-risk exposure and the sufficiency of their reserves to cover defaults under adverse and extreme conditions. They test the entire banking and financial system for shocks that might occur to the economy like unemployment rising precipitously, or stock market crashes, or GDP falling, or inflation rising, or the housing market collapsing and so on. These tests have been improved and done more often since the financial crisis in 2007 and 2008.
Stress-Testing Makes Lives Better
A most under-utilized yet potentially life-enriching area where stress-testing adds significant value is in the area of life-planning and investing. Unfortunately most in our industry working with individuals do not understand its value and life-changing potential or they are not compensated in a way to make it feasible. Commission sales are transactions involving discussion about a product and its appropriateness for a particular circumstance, whether for long-term savings or to address a specific short-term need, which more times than not are emotionally-driven.
Most brokers or insurance salespeople are not paid or motivated to spend a great deal of time understanding his or her client sufficiently well enough to develop an extensive goal/priorities-based plan and risk-appropriate investment portfolio that can be stress-tested. The process requires a consultative approach and is best administered by a fiduciary who counsels, not sells. Personal stress-testing, done well serves two vital purposes.
- It provides the client with robust statistical confidence that he or she will meet or exceed every goal they value in life. The importance of this fact cannot be overstated from an emotional standpoint. With a good understanding of what goals his client is aiming for and equipped with powerful tools to evaluate new data in light of market setbacks like this, the fiduciary advisor provides his client with an answer that is far more trustworthy and credible than a simple “stay the course – it will come back.”
- Just as aircraft and banks are twisted and pulled in their stress-testing, Monte Carlo stress-testing, done well, gives advisors and their clients a very good idea of how portfolios will perform in difficult markets and in good. The doing well depends on sufficient data and the careful modeling of assumptions to mimic how markets actually behave.
In essence, if you are sailing blind, without direction (goals or purpose) or without firm knowledge of the capabilities of your vessel – (a carefully designed and stress-tested portfolio), storms like these will be very difficult for you, and they come pretty regularly, whether you are ready for them or not. But if you spend time discussing with your advisor where you want to go and when you want to get there, if you do the work to virtually experience the bumps and turns along the way, testing yourselves and your assumptions accordingly, you will be infinitely better prepared to respond when tested by real-world circumstances. Market downturns will still be no fun, but they will increasingly lose their hold over you and your lifestyle. And you will make better decisions, improving the odds that you will land safely in the Hudson or on that tropical island of your dreams – birds and storms notwithstanding.
Please do not hesitate to call us with any concerns you have in these difficult times. If you are a planning client, we’ll climb back into the ‘simulator’ with you to reassess any of the aspects of your plan that worry you. If not, we’d love to demonstrate the power of our process for adding confidence where it might be lacking now as well as ensuring that you are taking no more risk (now that it is painful) than is absolutely necessary to meet your important goals.