Portfolio stress testing is often sought in times of market volatility. Unfortunately, this often boils down to doing too little too late. In this blog we’re going to cover what stress testing a portfolio is, and when and why you should do it.
What is portfolio stress testing?
We’ve written about the definition of portfolio stress testing in other blogs on this subject:
Portfolio Stress testing is an approach that looks at the risks and potential losses an investor faces. The process is both a science and an art. The science is in knowing how various investments have historically behaved. The art is in interpreting historical data and applying it to the current situation. A good stress test looks at both your investments and personal situation.
Stress testing of a portfolio is an important part of an overall risk management strategy, just as much as assessing your risk tolerance, rebalancing your portfolio, and performing ongoing monitoring of your investments. It can help you defend your portfolio from what we call tail risk events (shocks), or extreme market moves of more than three standard deviations from the mean.
Stress testing is forward-looking as opposed to being retroactive in nature. It looks at responses to scenarios that may happen instead of what has happened in the past.
When should you stress test your portfolio?
We recommend stress testing portfolios on an annual basis for people approaching or near retirement. Other times when stress testing is important are before an expected change in circumstance, such as leaving a steady paycheck for employment in a startup, before taking extended time off to care for a child or parent, or any other time when you expect to rely on your portfolio for living expenses.
How do you perform one?
There are many different ways to test, depending upon which assets you are examining. The portfolio stress testing methodology is the same whether you are testing stock or bond portfolios. Usually software is used to run a linear regression model, the purpose of which is to analyze the portfolio’s potential loss in response to changes in a number of factors.
Here are a few portfolio stress test examples.
For your investment portfolio
Below are the steps to stress test an investment portfolio.
When stress testing a stock portfolio, you would run a regression displaying the portfolio’s response to shocks and changes in risk factors as:
- Market volatility
- Supply shocks
- Changes in economic variables such as GDP growth and consumer confidence
- Geopolitical events
- Commodity price changes
If you were stress testing a fixed income portfolio, you’d look at:
- Duration, or sensitivity of the bond portfolio to interest rate changes
- Convexity, the change in duration
- Inflationary changes
- Credit defaults
For your non-investment portfolio
It’s also important to stress test assets that are not held in your portfolio, such as real estate, art, yachts, or a business. These can often be a significant contributor to your total wealth. Moreover, assets that are not publicly traded present liquidity risk, as it can be hard to recover the value of these assets once they have declined, as exiting can be hard to do in a short amount of time.
This would follow the same methodology: identify the risk factors and run a regression.
Let’s take real estate for example. How would you run a stress test on your real estate portfolio? The risk factors would be a decline in real estate property value, tenant defaults, lower occupancy rates, etc. You would then conduct an analysis in Excel involving various shock scenarios, and see how they would impact your cash flow and loan to value ratio.
For your total net worth
Net worth is defined as the total value of your assets, liquid and non-liquid, minus the value of your liabilities. It’s important to understand the non-portfolio risks that may impact your net worth.
To illustrate this point, many business owners have a large portion of their net worth tied up in their business, but they do not consider this when they think about their portfolio. A small business is essentially one large, micro-cap stock in their asset portfolio, but they (or their financial advisor) often forget to include that when they stress test their “investments.” For example, a business owner nearing retirement may feel that a $1 million investment portfolio is sufficiently conservative at 70% bonds and cash and 30% equity.
What would a stress test tell us about the risks present to this person’s net worth? When we consider their $1.5 million business, their portfolio flips to 72% equity and 28% bonds and cash, and 60% of that equity is concentrated in one high-risk stock!
Did we convince you to stress test your portfolio?
Portfolio stress testing is an important part of risk management, and only one of the many parts of managing your total wealth.
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