Stress Test Your Investments

It might not take a market meltdown to nuke your portfolio. Your investments could be vulnerable to many, more-minor missteps. To protect yourself, you need to put your portfolio on the treadmill and find out if it’s a toned-up investment machine, sufficiently diversified and properly positioned to survive financial stress, or a gasping geezer of overpriced issues and some leftover ideas.

That monitoring process is called stress testing. How do you begin? One way might be to see how risky your stocks and funds are according to two commonly available statistical measures: standard deviation and beta.

Standard deviation, or volatility, indicates the range of an investments returns or price over a period of time. For example, the Vanguard Index 500 Fund has a standard deviation of about 12 percent, according to mutual fund research firm Morningstar. Statistically, that means that two-thirds of the time, its returns have ranged from 12 percentage points above to 12 points below its average return. Since this average is about 21 percent, the fund has returned between 9 and 33 percent for roughly two-thirds of its life.

Beta, the second common risk gauge, measures the volatility of a stock or portfolio relative to some benchmark. The Vanguard Index 500 Fund, which tracks the S&P 500 index, has a beta of 1.0. That means that for every variation in the indexs returns, the fund should rise or fall by the same percentage.

Nonmainstream companies with minimal institutional ownership tend to have low betas. Those are the stocks favored by Charles Royce, manager of the Royce family of funds, who thus avoids high-traffic zones, where the odds of a crash are high.

Investments

You can reduce your risk simply by bringing your stock and bond proportions back to where they were 18 months ago. But don’t stop there diversify your stock holdings as well.

The asset mix is the primary determinant of performance and will also be the primary determinant of portfolio risk, says Jeff Schwartz, a consultant with Ibbotson Associates. What the diversified portfolio is offering you is protection from short-term hits to the domestic stock market, says Schwartz.

Now is a particularly good time to lighten an overweighting in the S&P 500. The indexs gains have been produced mostly by a small group of big companies such as Coca-Cola, Microsoft, and Gillette that are selling for huge price-to-earnings multiples. If the froth is knocked out of these stocks, the S&P will suffer disproportionately.

Among your individual stocks, you may want to prune those whose prices are not adequately supported by their business fundamentals and therefore run the risk of collapse should the market mood sour. To avoid just that danger, Charles Royce, for one, sticks with companies having low P/Es and low price-to-book ratios.

Your sector concentrations can also pose problems even more dangerous, perhaps, because the over-weightings may be less evident. Some investors just don’t know where their chips are placed, says Don Phillips, president of Morningstar. His characterization applies especially well to mutual fund holders. If you own stocks, there’s a chance you understand risks like aggregate sector exposure, he explains. But if you own funds, their managers could be shifting positions and taking steps you don’t anticipate.

When should you be concerned about the concentrations in your stock or fund portfolio? Whenever your holdings in any sector approach three times that sectors weighting in the S&P 500, suggests adviser Evensky.

Looking forward is great, but an appreciation of the past does not hurt either. In fact, one way to make a judgment about how an investment is likely to behave in the future is to examine how it has performed in the past.

We hope that a lot of people will use this tool to learn about risk and help to keep them from stepping on land mines, says Edleson.