Dev Ashish
Unlike many who rely wrongly on ill-given but free financial advice, you took the right decision to get proper professional financial advice. And, as a result, got yourself a financial plan made from an investment advisor.
This in itself puts you ahead of lakhs of people who randomly put their money here and there, in unsuitable products and without any proper strategy. So kudos to you first!
Now comes the important part—stress testing the financial plan.
A good advisor will always stress test the plan variables before giving you his final recommendations.
But what exactly is stress testing?
Testing your plan
Stress testing is a technique used to test the resilience of investment portfolios in potentially adverse scenarios. In a way, it is about running simulations (scenario analysis) to identify hidden (or often ignored) vulnerabilities in the investment portfolios. If done well, it will properly determine the ability of a financial plan to help achieve your financial goals. To put it simply, it’s about asking ‘What if…’ about a wide number of factors that influence your financial life.
No financial plan can guarantee 100 per cent goal achievement. But if a plan can ensure goal achievement with 90 per cent probability (or confidence level), then it is a well-made superior plan.
Let me take a small example (retirement goal) to explain all these points.
When it comes to retirement planning, some common variables used are:
- Current Age (let’s say 40)
- Retirement Age (60)
- Life Expectancy (85)
- Years to Retirement (20 = 60 - 40)
- Years in Retirement (25 = 85 - 60)
- Return before retirement (let’s say X per cent)
- Inflation before retirement (Y per cent)
- Return after retirement (9 per cent)
- Inflation after retirement (6 per cent)
- Annual Expense in the first year of retirement (let’s say Rs 6 lakh in today’s value)
For simplicity, let’s focus on things that are applicable only after retirement:
- Life Expectancy (85) (i.e. 25 years in retirement)
- Return after retirement (9 per cent)
- Inflation after retirement (6 per cent)
- Annual Expenses in retirement (Rs 6 lakh)
As you can see, we have chosen fixed numbers above. But in reality, we know that these can vary. Rate of return every year and inflation too can be different every year. Annual expenses, even though increasing with inflation, can still vary if some unexpected expenses come up. And this is where stress testing comes into the picture. We vary these factors to see its impact on corpus’s ability to fund 25 years in retirement.
Assessing the impact
Some of these four factors are (to an extent) in our control, while others aren’t. Expenses for example—we have a fair bit of control on them. There are basic non-negotiable expenses and then there are discretionary but non-mandatory expenses. Life expectancy is also not in our control. Inflation too is not under our control. Returns after retirement can, to an extent, be controlled via asset allocation but not fully as actual equity and debt returns fluctuate.
So, when stress testing the plan and in particular these variables, the following can be simulated one at a time or together:
- What if returns aren’t 9 per cent every year but range from 6 per cent to 12 per cent? In such cases, portfolio returns will be varied to see whether the portfolio lasts for 25 years (required number of years after retirement) or not.
- What if inflation isn’t 6 per cent but like in real life, varies from 2 per cent to 10 per cent? Now, during simulation, the inflation figures will be varied (each year) to see whether the portfolio lasts for 25 years (required number of years after retirement) or not. A varying sequence of annual inflation can be also used multiple times to see in how many possible cases the corpus fails to last for 25 years
- What if the retiree or/and spouse live to more than 85 years? Clearly, running out of money before running out of years is a scary scenario and the biggest fear of old people
So stress-testing the plan is done by taking various different factors into a simulation that permit us to observe how the plan would perform in various hypothetical scenarios.
The plan will indicate in which cases the plan would hold up and in which cases it won’t. If done well, this kind of stress testing can at least make you aware of unpleasant possibilities. And it’s always good to know such things when it comes to your finances.
Commonly done for larger portfolios, stress testing still has utility for everyone having a financial plan. Once a baseline financial plan is in place, a good advisor can do at least some basic level of stress-testing to check its robustness. And depending on the finding, the base plan itself can be revised. Some buffers (like saving extra) or lowering the return assumptions or increasing inflation assumptions can be considered—this will give the plan an increased ability to withstand unpleasant scenarios.
In financial life, the unexpected events aren’t about IF they happen but about WHEN they happen. And a good financial plan should be judged by its ability (and probability) to overcome such WHEN-IT-HAPPENs scenarios in life. And stress testing the financial plan can be a smart way to ensure that it delivers on its promises.
(The writer is the founder of StableInvestor.com)
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