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 risk tolerance. But the key consideration is that some sort of achievable goal, as well as a plan for how to reach that goal, is common to most investors.

However, this comes with a fatal flaw that we see all too often: these plans are made in a vacuum. You might think that if I continue to earn my current salary, save 10% and invest another 25%, I’ll be fine. Unfortunately, nothing happens in a vacuum, let alone in the world of investing.

The thing is, the circumstances under which you made your plan will most certainly change. Income can fluctuate (in expected or unexpected ways), interest rates change, inflation rises or falls, economies experience recessions, and industries collapse.

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

None of us can predict how the future will unfold. However, we can approximation of 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 drops sharply, will your limited savings force you to liquidate long-term investments to generate short-term cash, thus disrupting the whole of your retirement plan?

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

In practice, this process requires a large amount of knowledge and expertise. Most investors turn to financial advisors to help them with such a task. Whether you’re looking to do it yourself or considering turning to a trusted advisor, the following will give you a head start in both directions.

Stress Testing Your Portfolio: Considerations

The first and most crucial aspect of stress testing 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 unique 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 is not just to grow your assets; it is cash management.

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

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

If your budget is not clearly defined, you have already botched your stress test.

So, once you have set a budget and projected cash flow, the focus is on your portfolio. This is where things get a little complicated. Most portfolios are built using tools that only professional money managers can access. This is why it is always better to use a financial adviser.

First and foremost, two main concepts come into play in your stress test: asset appreciation and after-tax cash flow expectations. This is very similar to the strategies of 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 objective 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 of the ways to achieve this is the Sharpe ratio.

Simply put, the Sharpe ratio adjusts the expected return of an investment based on its risk. Let’s say Jerome and Sarah are both traveling from point A to point B. Jerome picks up his car, at a modest average of 45 mph. Sarah takes her motorcycle, at an average of 75 mph. Of course, Sarah reaches point B first. But – she also ran a lot more risk 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 illuminate.

Then there are stressors that need to be added to the mix. Most important should be a loss of primary income. Many experts suggest having three to six months of your salary readily available in cash in a savings or brokerage account. Too often, however, this is simply not enough. More conservative savers are aiming for a figure closer to 12 months. Again, we see how starting with a budget – for 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 adequately 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. continuing to work is one thing, but feeling obligated to maintain a stream of income is another. The portfolio stress test will help you better understand your readiness for life’s curveballs and hopefully help you sleep better at night.

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

One of the means by which financial advisers test different scenarios – and their subsequent impact on portfolios – is through 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, it is clear 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 valuable at all times.

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

Some of these factors are within your control – income, expenses and expected returns due to asset allocation are largely up to you. However, market conditions such as inflation, your investment horizon, and many other factors do not. Thus, 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 that sounds complicated, there’s no need to worry. Even if you are an experienced investor, this is a subject that requires professional experience in the field. The thing is, even if the software used to run the stress tests were available to the general public (which it isn’t), you would still have the trouble of deciphering the test results and using them.

Final Thoughts

It is a daunting task to test a financial plan on your own. Hiring a professional is the most popular route here. You can, however, do some prep work yourself to better understand the process and select a financial advisor you trust. Much of this preparation will revolve around budgeting and making contingency plans for yourself – think of it as your own prelude to a stress test.

Founder, Lakeview Capital

Tim Fries is co-founder of Protective Technologies Capital, an investment firm that helps owners of industrial technology companies manage succession planning and ownership transitions. He is also 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 lower-middle-market private equity firm.