Stress testing is widely used by institutional investors. However, with recent advances in computing power this tool has become accessible to advisors as well. Stress testing allows the user to specify different scenarios and to measure how they will impact the portfolio return. It is a perfect tool for financial advisors to educate their clients about risk and improve portfolio construction decision making.
The main reason stress testing is useful to advisors is that it is not a rear view mirror tool – it is a forward looking tool. For example, stress testing can show what is likely to happen to the portfolio when rates rise, something we haven’t seen in decades. Adoption of stress testing is also crucial because investors do not want to hear statistical jargon (e.g. standard deviations or Value-at-Risk quartiles). They want to hear clear explanations of the strengths and weaknesses of each portfolio.
For example, a portfolio can be hurt by interest rate changes, by interest rate changes and stock movements, by commodities prices; or by changes in diverse geographic markets, such as the US, Europe, Japan or emerging markets. RIAs need to design for all of these impacts to see how the portfolio responds. Combinations of any of these stresses and magnitudes manifest themselves in scenarios that can be named in a math jargon-free manner, using every day descriptions such as Global Stock Crash, Inflation, Global Recovery, Euro Meltdown, etc. Most clients will understand what these scenarios mean and an effective measurement and discussion of risk tolerance can take place.