Between firing up the backyard grill and lazing on the beach, there’s another activity you should be squeezing into your schedule this summer: giving your retirement portfolio a stress test.
Not that I’m saying a crash is imminent. But as Money’s Ian Salisbury recently pointed out, there are plenty of reasons to be concerned about a possible market setback, including the sheer age of this rally, lofty stock valuations, and excessive optimism on the part of investment pros.
Which is why now is a good time to gauge how your retirement portfolio would likely hold up if the market were to slump and make needed changes before a downturn occurs.
Here are the three steps you should take to do that:
1. Determine your stock-and-bond mix.
The past eight-and-a-half years of robust stock gains have done wonders to fatten retirement accounts. But if you haven’t been periodically rebalancing your portfolio as stock prices have climbed — by selling your winners to reset your strategy back to your desired mix — you could be more heavily invested in stocks than you think.
For example, a portfolio that started out 70% in stocks and 30% in bonds at the beginning of this bull market in March 2009 would be closer to 90% stocks/10% bonds today, assuming no rebalancing and that you reinvest of all gains.
So to understand the potential downside you face if stocks were to tank, you need to find out what your stock/bond allocation actually is.
To do that, just list all your stock and bond funds along with their current balances and then calculate the percentage each represents of your total portfolio.
If you own funds that hold both stocks and bonds—balanced funds, target-date portfolios, lifestyle funds, etc.—you can get the fund’s stocks-bonds breakdown by contacting the fund directly or plugging the fund’s name or ticker symbol into Morningstar’s Instant X-Ray tool.
One way or another, you need to know how your retirement portfolio is divided between stocks and bonds, as that mix will largely determine how much the value of your retirement savings will drop during a market downturn.
2. Calculate the potential damage.
There’s no way to know exactly how your portfolio will perform during a major market setback. But you can get a ballpark idea by looking at how different asset classes have fared in severe downturns in the past.
For example, in 2008 during the heart of the financial crisis, the Standard & Poor’s 500 index lost 37%, while the Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for the domestic taxable bond market, gained 5.2%.
Thus, a portfolio consisting of a 50/50 mix of broadly diversified stocks and bonds would have incurred a loss of roughly 16% that year, while more aggressive blends, say, 70% stocks/30% bonds and 90% stocks/10% bonds, would have taken a bigger hit — roughly 24% and 33% respectively.
Of course, more volatile asset classes took an even bigger hit.
Tech stocks, for example, lost about 45% in 2008, while high-yield and emerging markets bond funds experienced declines of more than 25% and 17% respectively. So if you’ve been loading up on FANG stocks—Facebook, Amazon, Netflix, Google (now Alphabet)—or stretching for yield by going into junk or emerging market debt, you’ll likely need to brace for somewhat larger losses than those sustained by a portfolio that more closely tracks the broad stock and bond markets.
Again, though, your aim here isn’t to try to forecast exactly how the markets in general or your portfolio in particular will perform. That level of precision isn’t possible. Rather, you want to get a reasonable estimate of what the downside might be if you enter a severe market correction with your current portfolio.
3. Decide if you need to adjust.
Once you have a ballpark idea of how much your portfolio’s value might drop during a big market setback, you can think about whether you ought to take action.
Let’s say that going through the process above shows that you have an 80% stocks/20% bonds portfolio that might lose upwards of 30% in a downturn like 2008’s. If you’re confident you could hang in during such a setback knowing that you’ll recoup your losses and more in the subsequent rebound, then you’re probably okay just sticking with your portfolio as is.
If, on the other hand, you feel that seeing your portfolio’s value plummet by that amount would freak you out to the extent that you’d begin jettisoning stocks and fleeing to cash, then you’ll probably want to consider scaling back your equity exposure to a level you’ll be able to tolerate during the market’s inevitable routs.
You don’t want to get too cautious, though. Remember, your goal isn’t to avoid losses every time the market heads south. If that were the case, you could simply keep your retirement savings in cash.
Rather, your aim to invest in a mix of stocks and bonds that can provide some shelter from market squalls, while also generating long-term returns high enough to build a nest egg capable of sustaining you over a long retirement.
So before you make any significant change your stocks-bonds mix, I suggest you also complete Vanguard’s risk tolerance-asset allocation questionnaire, which you can find in the Retirement Investing section of RealDealRetirement’s Retirement Toolbox.
After answering 11 questions, you’ll get a recommended blend of stocks and bonds based on how long you expect to keep your savings invested and how you would react to market turmoil.
By taking the tool’s recommended allocation into account, plus factoring in the loss estimate you arrived at above, you should be able to arrive at a stocks-bonds mix that provides the combination of return potential and downsize protection that’s right for you.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. FollowWalter on Twitter at @RealDealRetire.
More From RealDealRetirement.com: