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Now that we've seen a few rare down days in 2012, it might be a good time to stress test the portfolio. The past couple of years have started out well only to see a substantial increase in volatility. Maybe this year will be different, but I believe in erring to the side of caution when given a choice.

Stress testing is a fairly simple thing to do - just take a look at what outperformed and what sold off hard on a down day. For example, when the Dow was down 200 points earlier in the month, one of my stocks, Caterpillar (NYSE:CAT), was down 3.6%. The S&P 500 was down 1.5% by comparison. Now, I like CAT and expect it to do well over the long term, but I dislike portfolio declines more than I like CAT, so I took a look at what held up better than most dividend stocks and chose Pepsi (NYSE:PEP) to replace Caterpillar. At the time, CAT was up over 16% year to date and 36% over the past five months. That's a pretty good couple of years, much less few months. In comparison, Pepsi had not participated in the rally and in fact was down 6% for the year.

We all know that we're supposed to buy low and sell high in the markets - something easier said than done. In this case, exchanging CAT for PEP served three purposes. First, CAT was high and PEP was low based on both technical and fundamental metrics I use. I had set a price target when I bought CAT and it had reached it. That doesn't cause an automatic sell, but it does prompt me to start looking around for a replacement. Second, PEP pays a dividend of 3.2% to CAT's 1.7%. Dividend yield is not the only consideration, but it is a factor in a dividend portfolio. Third and most importantly, is by switching out CAT for PEP, I believe I've reduced the potential volatility of the entire portfolio. When things get a little dicey in the markets, investors tend to rotate from the higher risk stocks to the more tame offerings.

Of course, many would say that CAT has been a much better stock than PEP, and over the past six months, they would be absolutely correct:

But let's take a look at the past 12 months:

Not only has Pepsi posted slightly better performance, but it fared much better during the wild summer and fall we faced in 2011. I have no idea if that will be the case this year, but why take the chance if I don't have to? CAT has been a great holding since last fall and I'm almost certain I will be back in it sometime in the future, but this is part of stress testing the portfolio and making adjustments, especially after a big rally.

I find it helpful to look at how various stocks and sectors perform on big up or down days to try to form an idea of where money is likely to flow when a change in the overall market trend occurs. As I've often written, there is only one reason to own a stock and that's to make money. Once that has happened, it is important to protect those gains. Investors should ask themselves which would make them feel worse; missing out on more gain on a stock or watching a nice gain go away. For me it's the latter. The market may very well continue on an upward trend and I could miss out on some performance on CAT versus PEP, but that's fine. Managing risk is one of the most important parts of investing and managing stress is an important part of life. By stress testing the makeup of the portfolio on big down days, I can manage both at once.

Source: Time To Stress Test The Portfolio