What Is Stress Testing
Portfolio Stress Testing is a useful method for determining how a portfolio will fare during periods of financial crises. The financial crises scenarios are modeled and may include historical events (e.g. 2008-like scenario) and events that we have not observed yet.
Advantages of Stress Testing vs. Traditional Risk Measures
1. Traditional measures are backward-looking, and Stress Testing is not
Why do we need Stress Testing when we already have risk measures like Sharpe ratio, Beta, Value-at-Risk, Tracking Error, and Expected Shortfall? The problem with these measures is that they are completely backward-looking. A tracking error or a Sharpe ratio today has no clue that interest rates can actually rise by more than trivial amounts, since nothing of that kind was observed in the data sample used to calculate those metrics.
Moreover, if you ask one of these measures about the possibility of a simultaneous rise in interest rates and a drop in equities, it will likely tell you that the probability of such a one-two punch is zero. When those measures will gain that knowledge, it will be too late to be useful, since the events will have already happened. Backward-looking risk measures still view longdated Treasuries and any instruments with a great deal of interest rate risk as virtually riskless, due to the low volatility and safe haven appeal that we have observed over the recent decades. This will lead you to underestimate probabilities of events that are quite plausible in the next few years, such as inflation or stagflation.
2. Stress Testing is effective in prospecting by connecting to clients’ dreams and fears
There are clear benefits of using Stress Testing in work with your prospects. Since investors get a lot of information from the press covering various world events, many prospects have fears of what would happen to their wealth if any of the frightening events materialized. And it frequently happens that when a fear is not measured it can grow disproportionately big in the prospect’s mind. And Stress Testing allows the advisors to put a price tag on the fear, i.e. to quantify it. Quantification of the potential damage of disastrous scenarios is the first step in evaluating various portfolio options. For example, based on our close work with many advisory firms, a while back a very “popular” fear was that of the Greece exiting the Euro zone, later the ISIL taking over Iraq was on investors’ minds.
3. Usage of Stress Testing by advisors is in line with the rest of the financial industry
Have you noticed how Fed stopped talking about Value-at-Risk for banks? It practically disappeared from popular discourse starting in 2009. The Fed and the ECB now routinely talk about stress testing of banks. Of course, stress testing can also be misused and gamed by the banks, but at least they realized that estimating risk simply based on what happened over the past couple of years is a rather flawed strategy. Based on the fact that the usage of Stress Testing is quickly increasing among financial institutions and is demanded by the Fed, we expect its usage to grow very fast in the financial advisory services.