By TaipanPublishingGroup.com
Remember back in 2009 when the government required banks to take stress tests to see if they could handle another financial crisis? We learned a lot about how safe banks were from those tests. Many of them had to raise the amount of cash they held, just in case more loans went bad.
Well, maybe we should all be putting our investment portfolios through a stress test.
I was reading a Wall Street Journal article on this very idea yesterday. Most of it focused on diversification. (We’ve talked a lot about this idea here in Smart Investing Daily.) But that’s not really a test, is it? It’s more of a solution for some investors.
A MarketWatch.com article also talks about stress-testing, and offers a way for you to test your portfolio.
It says, “When planning for retirement, assume negative investment portfolio returns and high inflation in the first two years of retirement.”
For this test, you will need to know how much money you have in your retirement nest egg. You’ll also need to know how much money you will need to live on for a year. This is your “annual distribution.” And to make this test realistic, you will need a list of investment portfolio returns. Using an average return won’t give you realistic results.
Finding the Right Figures
You could use your financial advisor’s annual returns for the past few decades. The longer the time frame, the better.
(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the retirement process for you with our easy-to-understand investment articles.)
For simplicity’s sake, I chose to use the Fidelity Balanced Fund as our example for today.
Note: This is not an endorsement of any Fidelity fund, nor does Smart Investing Daily have any affiliation with Fidelity Investments.
This fund has returned 9.41% a year over its lifetime. Not bad… But that return masks the -31.31% the fund had in 2008. That’s why it’s important to look at actual returns on a year-by-year basis.
Take a look:
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |
| 5.32% | 2.25% | -8.49% | 28.24% | 10.94% | 10.68% | 11.65% | 8.99% | -31.31% | 28.05% |
Now, let’s get down to the nitty-gritty. Here’s a chart of the Consumer Price Index changes for the same years:
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |
| 3.4% | 1.6% | 2.4% | 1.9% | 3.3% | 3.4% | 2.5% | 4.1% | 0.1% | 2.7% |
This is inflation, and it eats away at your portfolio gains. These are middle-of-the-road figures. We’ve seen much higher inflation — back in 1979, inflation was 13.3%. We’ve also seen severe deflation — in 1921, inflation was -10.8%.
Stress-Test Your Investment Portfolio
Here’s your stress test. Take your annual payout from your retirement fund, and raise it by the CPI figure. That means if you’re taking out $50,000, and inflation is 3.4%, your following year’s payout will be $51,700. The year after that? Your payout is $52,527, using 1.6% inflation from the CPI chart above.
At the end of 10 years, your payout has increased to $64,218, just to keep up with inflation!
Next, for each year, you’ll need to account for your portfolio gains and losses. Let’s say your portfolio is $1 million strong. At the end of a decade, using the gains and inflation figures above, you will have $966,135 left in your account.
At the end of 30 years, your annual payout climbs to $105,994, and your nest egg has only $37,025 left.
Note: To find these numbers, we repeated the decade of annual fund gains and annual CPI.
Is 30 years enough for you? Maybe… But let’s add some more stress. Let’s bump up inflation and slash some gains. This will help you find out if your $1 million portfolio will last you long enough.
Let’s say that for the first two years in the Fidelity Balanced Fund, it didn’t make any gains. And let’s say that inflation was at 5% and 6% respectively.
With these new rates, $1 million only lasts 22 years!
In fact, if you want your nest egg to last 30 years in this stressful environment, you’ll need to have another $275,000 tucked away.
But now, let’s say the first two years of your retirement, your investment portfolio loses value. A modest 5% loss for both years. Your $1 million portfolio lasts only 19 years. You’d need more than $1.5 million in order to make it through 30 years of.
Making Smart Decisions
Obviously, these are only tests. We can’t say for sure how high inflation will be over the next decade or three. And we don’t know how well portfolios will perform, either. But testing your portfolio can give you a better idea of how ready you might be for retirement.
You may need to adjust your lifestyle now and try and save some more before you retire. You may need to rethink your standard of living for your retirement. In the worst stress-test example, a $40,000 payout at the start of your retirement will make your portfolio last six years longer.
There are lots of unforeseen risks out there. And there are known risks with uncertain values, like inflation.
You know the expression, “Expect the best, prepare for the worst”? This can be applied to your retirement strategies as well. So put your portfolio through a stress test, and see if it can withstand some hard times.
You might be surprised at what you find out.
Editor’s Note: When I sifted through this huge government report, I couldn’t believe my eyes. Now I’m saying “what recession?” While others were losing their retirement accounts and jobs, I discovered this secret billionaire blueprint. Works in an up market or down. I’ll tell you all the details here…
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