Portfolio Stress testing is an approach that looks at the risks and potential losses an investor faces. The process is both a science and an art. The science is in knowing how various investments have historically behaved. The art is in interpreting historical data and applying it to the current situation. A good stress test looks at both your investments and personal situation. For example, a real estate agent might have most of their investments in what else? – Real estate. A recession in the real estate market may present a great hardship since the value of the agent’s investments is likely to go down at the same time the agent’s income drops. A stress test would help determine the financial cost of such a situation by estimating the loss of property value and income while comparing those to the ongoing obligation of business, living, and investment expenses.
Special requirements are those objectives that make your situation and investment goals unique. All investors want to make money. However, each investor’s individual goals will define a portfolio’s special requirements. For example, a trust set up to provide for nursing home care will have very different requirements than a KEOGH plan set up by a self-employed 45 year old. Dependable cash flow is one the most common special requirements. Currently, the stock market as measured by the S&P 500 index pays about a 2% dividend. Any additional return from stocks must be in the form of capital appreciation. Unfortunately capital appreciation is not a dependable source of cash flow. For example, assume you need dependable cash flow equal to 6% of your portfolio per year. Also assume that most of your money is in stock mutual funds. Since stock mutual funds produce an average cash flow of only 2% per year, this investment would not meet your special requirement.