My work requires me to fly a lot. Although I began as a nervous flyer many years ago, the experience I’ve gained over several hundred flights has taught me what each sound on the airplane means and to not be alarmed when turbulence arrives. My kids don’t share my experience and tend to get nervous when things get bumpy. It’s at those moments, when my kids are nervous, that I always appreciate hearing the pilot say, “Ladies and gentleman, don’t worry, everything is going to be ok.”
Investors tend to feel the same nervousness. When the investment ride starts to get a bit bumpy, it’s always nice when the professional running the portfolio is able to say, “Don’t worry, the portfolio was built to handle this, and everything is going to be ok.”
Why we stress test portfolios
Turbulence in the air can be caused by a variety of things—a strong jet stream or bad weather, to name two—but importantly, the impacts of many different forms of turbulence have already been tested on the plane before it’s allowed to be put into service.
Similarly, when building an investment portfolio, we should gain an understanding of how it might behave in different scenarios. This is how we prepare for difficult spots in the markets and maintain confidence that the portfolio is ready for trouble should it occur. This confidence is critical, because it keeps us from making rash decisions at stressful moments based primarily on our emotions.
Possibility, probability and impact
Stress testing should be done for the events you think might happen, but it’s also important to test for things you haven’t really thought about. Not many people considered that the banking system would seize up in 2008, and the result was a crisis that few portfolios were prepared for.
Three things to think about:
- What’s ? Widen your view. Those who built the Titanic thought it was impossible for an iceberg to sink the ship. How strong are your beliefs? History is littered with moments where the impossible was proven to be possible.
- How is it? The greater the probability of an event, the more we should test—and prepare—the portfolio for it.
- If an event occurs, what will its be? If the impact is tested to be low, we may not need to worry about it as much; but if the impact is high, then we need to prepare the portfolio for it in some way, even if we assign it a low probability.
We should be most aware of events that will have a large impact on our portfolio, regardless of how probable they are. Conversely, even if an event may be highly probable, if its impact is low, then we may not need to do much, if anything.
Don’t dwell on the past
There are many tools available to assist in stress testing, but how each completes the test is important. Many test environments seek past moments in history when the scenario you are worried about has previously occurred. If you think interest rates will rise and are worried about how the portfolio will react, you can look at other moments in history when rates rose to see how the exposures you own today behaved. This type of testing is a bit suspect. The market environment didn’t look the same back then, and neither did the holdings in your portfolio.
Consider someone who owns an exchange-traded fund tracking the S&P 500 and is worried about a repeat of the 2008 crisis. Looking at how the S&P 500 did back then would be misleading because there are nearly 170 new companies in the S&P 500 today that weren’t in the index back then. The sector weightings are also different, as are the weightings of every company in the index. Today’s conditions don’t look the same either. The level of interest rates or the price-earnings ratio on stocks are two examples of market conditions that could produce different scenario results between two time periods. Stress tests built to consider the actual holdings in the portfolio today and the current conditions are much more useful in estimating what might happen to your portfolio, should any scenario play out in the near future.
S&P 500 Scenario Test
Don’t cling to the worst case scenario
Stress testing a portfolio is only part of the process. While it is important to consider the possibility, probability and impact of a large negative event, it is equally important to recognize that we will see many more “normal” days than extreme events, and if we’re too busy building maximum protection against the worst case scenario, we may hold the portfolio back from providing what it’s meant to deliver—our goal return.
At BlackRock, we have developed a Scenario Tester tool that financial professionals can use to test their clients’ portfolios against various scenarios. Using the portfolio’s current holdings, we’re able to understand the potential impact an event may have without trying to form guesses using historical events that likely took place in different environments. This approach provides us the confidence we need to make good decisions when things get bumpy.
Many things go into a successful flight. But with proper stress testing, we can ensure that a little turbulence won’t keep us from flying.