Cars are routinely crash-tested for your protection. Why wouldn't you do the same thing with your stock portfolio?
Crash-testing a portfolio is the exercise of assuming some shock to the financial system and estimating the effect on your stock portfolio holdings. You already do this in to some extent when rebalancing your portfolio and looking for investments – for example, with rising instability in oil-producing regions of the world (purely hypothetical, of course…), how would you adjust your holdings?
Simplistic evaluations like this help, but they cannot take into account the massive interactivity and potential confounding factors that real life situations present. Risk analysis systems have been around for ages, but they tend to be more focused, simplistic, and microeconomic in nature.
The main reason you haven't been crash-testing your portfolio is that you don't have the massive information database and tools to do it correctly on an individual basis, any more than you would be able to simulate crash-testing cars in your computer (or, for that matter, actually crash-testing cars in your backyard). However, more sophisticated technology for crash testing is working its way down to the broker and financial analyst level – and to a certain extent, the consumer level.
A relatively new breed of macroeconomic stress testers are now available that are focused on assessing broader chaotic interactive events that can shock the financial system. There are three major players in the field: MacroRisk Analytics, HiddenLevers, and RiXtrema.
MacroRisk Analytics is the oldest of the three, having been around since 1999. It was, and still is, targeted to financial professionals to use in analyzing and building client's portfolios. It evolved from a simpler analysis of the effect of shifts in factors such as gold prices and the CPI to a system that analyzes portfolios and optimizes them against certain risk factors.
HiddenLevers is more oriented toward interactive discussions between brokers and their clients. The intent is that clients can address more direct issues related to their own concerns, such as "I am worried about spikes in inflation" or "What happens to my portfolio if war breaks out in the Middle East?" Several organizations have given approval for the interactive use of HiddenLevers with clients, including Raymond James Financial (NYSE: RJF) and LPL Financial (NASDAQ: LPLA).
RiXtrema is the newest entrant in the field. While it is targeted toward financial professionals, it cleverly allows anyone to crash test their own portfolio on their website (www.portfoliocrashtest.com). The focus is on balancing risk and return under different scenarios in order for individual investors to be able to better put their risk in perspective.
In other words, by displaying expected returns under different scenarios along with the risk, you can assess whether you can tolerate the risk necessary to meet those goals. If not, you should adjust your portfolio and/or reassess your goals.
You may be tempted to do your own crash-testing analysis, and experimenting with the RiXtrema system is good way to practice. However, before acting on any of these scenarios, consult your broker or financial planner – unless you have significant expertise in the field and access to suitable versions of the software.
Otherwise, you may end up with results similar to conducting crash tests on your car in the backyard. You may have learned something but done so at the cost of totaling your car – or in this case, your portfolio. A diversified portfolio that includes stocks plays a vital role in helping you to save for retirement. Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.