When clients ask: How do I stress-test my portfolio?
Ron Piccinini, PhD
January 11, 2018
To help you talk risk with clients, Ron Piccinini, Ph.D., answers some common client questions here. Ron, Covisum’s director of product development, is an expert on quantitative risk modeling, heavy-tailed distributions and risk management.
How can you stress test a portfolio?
In its purest form, a portfolio stress test aims to estimate the impact of an economic scenario on one’s portfolio. For example, if oil, interest rates or gold were to increase or decrease, what would be the likely impact on a portfolio? These questions are very valuable if the things a client is worrying about are front and center of his or her business. For example, if a client is running a bank, interest rate movements can have a huge impact on value. Or if one’s running an airline, oil prices are important.
However, for an individual investor with a diversified portfolio, this exercise has marginal value. What is most relevant is to get an estimate of how much value your portfolio can lose in the time it takes you to react. For example, if you own a diversified stock portfolio mimicking the S&P 500 index, you could realistically lose 8% of your portfolio on a bad day, 11% in a week, 18% in a bad month, 25% in a quarter, 45% in a year. Could you lose more or quicker? Yes, though with lower probability.
So how do you advise your client? Tell them to know and write down how much loss they can stomach before they make investment/trading decisions. For example, if they decide that they cannot tolerate a loss greater than 15% of their portfolio in a given year and their portfolio is comprised entirely of large cap U.S. stocks, they have two choices:
Reduce the risk by increasing the cash or low-risk allocation until the portfolio is extremely unlikely to generate such a loss.
Exit the market as soon as their loss threshold is met. The big disadvantage of the second option is that they will have to make a decision about when to re-enter.
You can explain risk tolerance to your client like this: the acid test is to put yourself in the shoes of a lender, and ask yourself, “How much money would I be willing to lend if a total stranger came to me with this portfolio as collateral?”
Encourage your clients to be honest with themselves. That’s their portfolio stress test.
How can you assess a portfolio's level of risk and how it might respond under certain conditions, such as a market correction?
This is very difficult. While it’s easy to look up the history of a portfolio and see how it performed in the last correction, history isn’t likely to repeat itself. Correlations vary significantly from their “normal” levels in times of financial stress, so relying on historical (co-) relations is a very risky bet.
A safer approach could be to estimate what a bad scenario for each holding in your client’s portfolio looks like. Sum the losses for each holding, and that is the amount of loss you’re facing if there is no diversification effect. If you’re lucky, some holdings will zig when the others zag, and you will realize lower levels of losses.
How can Covisum help?
Advisors and financial institutions rely on us to help them guide their clients to make the best financial decisions. With our proven process, advisors are able to streamline their practices, offer actionable insights, and utilize successful marketing tactics.
Clients are often blind to market risk and typically don’t have accurate downside expectations – either too conservative or too reckless, leading to sub-optimal investment allocations. With SmartRisk, advisors can analyze portfolio risk and easily communicate with clients to help them avoid costly mistakes. Additionally, when you subscribe to the software you get an entire support team to help you client and software questions.