Principle #7 - Stress Testing Your Investments

Investing means assuming risk. Risk can mean either the possibility of loss or simply the variance of returns from expectations. All investments carry risk - there are no exceptions and, in the real world, there is no such thing as a risk free rate of return. Also, as a general statement, the higher the expected rate of return, the higher the risk (although the relationship is not always a linear one).

Predicting returns on investments is difficult. Measuring the corresponding risks is also difficult. Many extremely intelligent and very experienced investors and academics have been on record as making some spectacularly bad decisions. I have no reason to suppose that my ability to predict the future is any better than average. However, in order to make sensible investing decisions, in order to plan for contingencies, it is necessary to make an attempt. This will give you an indication of the potential for things to go wrong and, if they do, how badly. This analysis is particularly important in situations involving debt financing (e.g. mortgaged property) or where there is a possibility of losses exceeding the amount invested (e.g. futures trading) or where your ability to tolerate a loss is limited (e.g. if you are near retirement).

An example of my approach to stress testing my investments in real estate is here. In reviewing this part of the private portfolio, I listed the things that could go wrong: vacancy, rising interest rates, falling net yields and declining market value being the obvious potential sources of danger. There are of course other potential risks, but I considered these sufficiently remote to be ignored. Looking at the list of risks, I then considered the portfolio's ability to service the mortgage obligations should they eventuate. I concluded that rising interest rates and falling yields would have only a limited effect on debt servicing capability. As an investor looking for long term yield who starts with a positive cash flow and a healthy level of income, I was not overly concerned about the risk of declining market values. It would hurt, but would not ultimately affect the cash flow. The most substantive risk was the risk of vacancy. It is a small portfolio and even a single vacancy would result in negative cash flow.

Having identified the risks and made some attempt to quantify them, I then considered a contingency plan to deal with them should the need arise.

I still need to do the exercise for the rest of the private portfolio.