How exactly do you test your financial plan?


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

Along with that, however, comes a fatal flaw that is seen far too often: these plans are made in a vacuum. You might think if I keep earning my current salary, put in 10% savings, and invest 25% more, then I’ll be fine. Unfortunately, nothing happens in a vacuum, especially in the world of investing.

The point is, the circumstances in which you have drawn up your plan will most certainly change. Income can fluctuate (either unexpectedly or unexpectedly), interest rates change, inflation goes up or down, economies go into recessions, and industries collapse.

This means that our immediate cash flow needs and the risks associated with certain investments can also fluctuate significantly. Their impact on our long-term financial plan is critical.

None of us can predict how the future will unfold. However, we can what would happen to our portfolio if some of these initial factors were to change. The basic idea is not too complicated: if your main source of income declines sharply, will your limited savings force you to liquidate long-term investments to generate short-term liquidity, thus derailing the economy. your entire retirement plan?

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

In practice, this process requires a great deal of knowledge and expertise. Most investors turn to financial advisers to help them with such a task. Whether you are looking to do it on your own or are considering turning to a trusted advisor, the following will give you a head start in either case.

Stress Testing Your Portfolio: Considerations

The first and most crucial aspect of a stress test is to start with a budget. Calculating your budget will allow you to forecast cash flow needs over time.

Understanding your cash flow needs, which are specific to your income, financial goals, and lifestyle, allows you to recognize the most important aspect of successfully managing a financial plan over time: your goal won’t. it’s not just about growing your assets; it is liquidity management.

Life happens – and we all end up with unexpected cash flow needs. The last thing you want to do in such a situation is liquidate a long term investment to meet short term cash flow needs. This will not only hijack your long-term financial plan, but you will likely incur additional immediate expenses through capital gains tax.

When most investors think about their financial plan, they think long term. And that’s great, but everyone needs to be prepared for a rainy day in the immediate future. The key to finding that balance between a long-term view and the immediate future comes down to liquidity management, which begins with setting a budget first.

If your budget isn’t clearly defined, you’ve already botched your stress test.

So once you’ve set a budget and projected cash flow, the focus then shifts to your portfolio. This is where things get a bit tricky. Most portfolios are built using tools that only professional fund managers can access. That is why it is always better to use a financial advisor.

Importantly, there are two main concepts at play in your stress test: asset appreciation and after-tax cash flow forecasting. This is very similar to the strategies behind many large endowment fund managers, but only on a micro-scale.

In practice, this usually involves looking at risk ratios to calculate expected returns and volatility from modern portfolio theory. The obvious goal is to maintain the lowest risk ratio for the highest expected value. A key element is to maintain the balance between risk and reward, and one way to do this is the Sharpe ratio.

To put it simply, the Sharpe ratio adjusts the expected return on an investment based on its risk. Let’s say Jerome and Sarah are both traveling from point A to point B. Jerome takes his car, at a modest average of 45 mph. Sarah takes her motorcycle at an average speed of 75 mph. Of course, Sarah reaches point B first. But – she also took a lot more risks than Jerome – despite the fact that they both reached the same destination.

Was the risk Sarah took worth the benefit of arriving early? Of course, the level of risk you’re willing to take on will vary depending on your particular situation, but that’s the kind of idea the Sharpe Ratio aims to shed light on.

Then there are certain stressors that need to be added to the mix. The most important of these should be a loss of primary income. Many experts suggest that three to six months of your salary be readily available as cash in a savings or brokerage account. Too often, however, this is simply not enough. More conservative savers aim for a figure closer to 12 months. Again, we see how starting with a budget – determining monthly expenses and managing short-term cash flow needs – plays a crucial role.

For most people, the end goal of this whole process is to properly 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. To make a choice continuing to work is one thing, but feeling compelled to maintain a source of income is another. Testing your portfolio will help you better understand your preparation for life’s vagaries and hopefully help you sleep better at night.

Of course, the above steps are fairly easy to understand in theory, but are much more difficult to perform in practice. Budgeting, measuring risk and assessing expected value are difficult tasks. While not necessarily impossible to achieve on your own, the framework above – at the very least – should be used as a template when selecting a financial advisor.

One of the ways that financial advisers test different scenarios – and their subsequent impact on portfolios – is by using Monte Carlo simulation.

Monte-Carlo simulations

Dwight Eisenhower once said, “Plans are nothing, planning is everything. Although the first part of this sentence may be too harsh, one is forced 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 – is invaluable at all times.

Monte Carlo simulations work by taking a financial plan and simulating its evolution under different conditions; the most important of which are the changes in your income and expenses, your savings, your life expectancy and the expected returns on long-term investments.

Some of these factors are in your control – the income, expenses and expected returns from asset allocation are largely up to you. However, market conditions such as inflation, your time horizon, and many other factors do not. Thus, in order to obtain a result, the Monte Carlo method assigns a random value to these uncertain factors. The simulation is then run thousands of times to obtain a probability distribution.

If this sounds complicated, there is no need to worry. Even if you are an experienced investor, this is a subject that requires professional experience in the field. The point is, even if the software used to run the stress tests were available to the general public (which it is not), you would still be worth the trouble to decipher the test results and use them.

Final thoughts

It is a daunting task to test a financial plan on your own. Bringing in a professional is the most popular route here. However, you can do some prep work yourself to better understand the process and select a financial advisor you trust. Most of these preparations will revolve around budgeting and making contingency plans for yourself – think of them as your own prelude to a stress test.

Founder, Lakeview Capital

Tim Fries is co-founder of Protective Technologies Capital, an investment firm dedicated to helping owners of industrial technology companies manage succession planning and ownership transitions. He is also the co-founder of the financial education site The Tokenist. Previously, Tim was a member of the Global Industrial Solutions investment team at Baird Capital, a Chicago-based private equity firm.

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