Stress-Test Your Financial Plan (Guiding Principle #3)
In my last few posts I have discussed my first few guiding principles for wealth management: make your balance sheet your friend and compare your financial plan to standards of excellence. Today I will discuss the third principle:
Back-test and stress-test your financial plan under various scenarios to further reveal strengths, weaknesses, and possibilities.
The “Elastic Limit” is a term I’ve borrowed from engineering because it has tremendous relevance in wealth management and financial planning. It refers to the amount of stress a material can withstand before undergoing permanent deformation. For example, if you stand on a wooden bench, the wood may sag a bit and bounce back when you jump off. However, if several NFL linemen stand on the same bench, the wood will probably warp, crack, or break.
In wealth management terms, the elastic limit is the stress your balance sheet can absorb before becoming irreparably damaged. It is not simply a function of net worth. A well-built $2 million financial plan can fare much better in the long run than a poorly constructed $20 million plan.
Too many financial advisors all but ignore worst-case scenarios in their planning. They use average market performance to project your situation in the future, assuming, for example, that inflation will stay at 3% to 4% annually, and market returns will conform to their historic 8% average. But life does not conform to the law of averages. If it did, all American families would have 1.86 children.
Other financial advisors are somewhat more sophisticated. They calculate long-term risk by employing a Monte Carlo analysis†, which can generate thousands of scenarios. The resulting report can look very comprehensive and impressive, but there’s a problem. The analysis almost always excludes the extreme ends of the bell curve. If you ran a typical Monte Carlo analysis of weather on the Gulf Coast, it would have shown the risk of hurricanes, but excluded both Camille (a catastrophic Category 5 hurricane in August 1969) and Katrina (a Category 3 hurricane in August 2005 that proved to be one of the two deadliest hurricanes and the costliest hurricane in the history of the United States).
The best way to stress-test a portfolio is to look at what markets have done historically, and assume that what has happened before might very well happen again. My own team uses 110 years of actual market and inflation data (earlier data is not considered reliable). This data set allows us to analyze any financial plan and portfolio and determine how well it would have fared in the best, the median, and the worst financial climates, all viewed in terms of 40-year increments. If the plan’s elastic limit is not strong enough to withstand worst-case scenarios, it can be reinforced in ways that don’t significantly reduce the plan’s performance in favorable market cycles. The goal is to achieve at least a 95% likelihood that the plan is “Depression-proof,” and, if possible, to design a plan that has a zero percent probability of depletion.
†Monte Carlo analysis: A mathematical means of analyzing complex instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes.
Joseph J. Janiczek is the founder and CEO of Janiczek Wealth Management, a top Denver-based financial advisory firm* serving clients across 25 states. This article is adapted from his book, Investing from a Position of Strength.