Stress Testing Portfolios

 In Strategy Updates

We believe in stress testing client portfolios. Unlike most firms, we put a lot of effort in managing significant downside risk and stress testing portfolios.

In our work we can stress test in several ways which include a portfolio’s asset allocation, sector exposure and individual stock holdings.

Asset allocation:  How exposed to the stock market is the portfolio?  This is a great gauge as to how it will perform in a difficult market. Portfolios that are allocated 100% to a diversified group of stocks will likely experience a similar decline as the S&P 500 or a global stock index such as the MSCI All World Index. Portfolios with less exposure will experience less significant declines. For example, in a normal bull market corrections typically are in the 8-10% range and occur about 2-3 times a year. An all stock portfolio would experience similar gyrations during these periods. A portfolio that is only 50% stock would experience declines of just half this amount. In bear markets like 2008, 2001-2, 1983 and 1974 stock indexes often fall 30-60% and all stock portfolios typically have similar catastrophic declines.  Asset allocation is one way to stress test your portfolio for many of these potential and different outcomes.

Sector Exposure:  Beyond how much stock a portfolio has, investors can stress test by the amount of stock held in different sectors. There are 10 sectors in the global economy:

  • Consumer Discretionary
Consumer Staples
Energy
  • Financials
Healthcare
Industrial
  • Materials
  • Technology
  • Telecom
  • Utilities

Each of these sectors fare differently in corrections and bear markets. For instance a portfolio of only tech stocks will likely fall much more than a diversified stock index, while a portfolio of consumer staple companies such as Proctor & Gamble and Unilever will fall much less. This has to do with the inherent business risk in these sectors and their inability or ability to generate profit growth in different economic scenarios. Investors should look inside their portfolios to see how they are weighted by sector to stress test what would happen should stock indexes fall dramatically. Since we only use individual securities (stocks, bonds etc.) this easy for our team to do.

Individual Company Exposure: 

Investors should be aware of the stock holdings in their portfolio for many reasons including stress testing. A portfolio of only fast growing small early stage companies experience dramatic declines in bear markets, while those that are more seasoned decline similar to popular indexes (which in a bear market isn’t great either).  A portfolio of high risk companies in high risk businesses often can fall by twice the market indexes. There is also the risk of associated with each specific company in a portfolio. This relates back to sectors but also to the strength of each company’s balance sheet and profitability. Sometimes companies experience difficulty which is related to their business or other hard to predict events that can cause them to decline very significantly. Since we use stop loss orders on our client portfolios, we can gauge what is normal downside volatility or stress for each company and what is more than normal. Stop loss orders are set to sell stocks when they break down beyond normal declines, which prevents us from suffering from catastrophic losses  – and the stress that results from these events.

 

Fees: Fees play an important role for performance in up, but especially down and flat markets. Most investors pay too much in fees for advice. Management fees plus fees for funds etc. These fees really add up in declining markets and make a bad situation worse. Investors should make sure that they are aware of the total fees they pay their advisor and include the fees included in the portfolio of investments to mitigate the drag that fees can have on performance – especially in bad markets.