The stress tests designed by the Federal Reserve and Treasury Department were made to assess a basic financial solvency measure -- the ability of these firms to weather a difficult economic storm. How will banks survive a potential greater downturn in the U.S. economy?
Hopefully, we will have a better idea in early May when the results are released. But maybe you should do your own stress test as well. With all the talk of financial institutions undergoing stress tests, perhaps it's also time for individual investors to review how they might handle a
tough economic storm. If it's good enough for Citigroup and Bank of America , it’s probably good enough for you as well.
Investors tend to be a very positive group in general, waiting for opportunities to invest and grasping onto green shoot indications that economies and markets are turning the corner. That’s fine as long as you recognize you must also take care to invest in a way where survival is assured if the markets and the economy turn out worse than expected. Or different than you think.
Investing as if the world might not turn out your way is the hallmark of great investors. Hedge and mitigate risk. The best investors, long and short, do exactly this. They invest with a healthy appreciation that events sometimes play out in unexpected ways.
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Hedge against risk by holding cash for future opportunities or diversifying your portfolio so you can weather an unpredictable storm.
You can short positions or buy defensive assets such as gold and commodities as a way to moderate your risk. There are plenty of ways to hedge. Whatever method you choose, the key issue is to invest with an understanding that there are many possible outcomes and you won't always be right. It's impossible to know for sure what the future holds. It's entirely possible that you could be more positive or pessimistic than you should be and that’s a danger. It’s not easy, but wise investors do their best to not let all or nothing dogmatic thinking rule the day.
The stress tests are designed to protect the U.S. economy and banks from nasty surprises and overly positive hopes and expectations. This is probably good advice for the average investor as well.
Do your own stress test. Look at your cashflow and your assets. Will your investments help you survive no matter what the world looks like 12 months from now? Have you bet too much? Or too little? Assess your plan and adjust as needed.