Prep Your Portfolio for Disaster With a Stress Test

Ernest Dawal, chief investment officer for private wealth management and institutional investment solutions at Sun Trust Bank, says the process isn't as easy to accomplish for do-it-yourself investors to accomplish as it is for a financial industry professional.

"If you have an existing portfolio and you want to stress test it , there aren't that many good technological solutions available to just press a button and say, 'How would my portfolio do?'" he says. "The individual investor out there may not have it within their current means to do that, but if they have a professional money manager or asset manager they can take that portfolio and put it in a variety of complications that would allow them to see how it would have done in the context of historical events. We can give the client a better feel for what to expect if we saw, for example, a large drawdown of growth assets, a sell-off in the markets or a rising interest-rate environment."

"We do a lot of that analysis, in terms of strategy and tactical solutions, in our 'model' or recommended portfolios," he adds. "We don't always do it for the individual client portfolios because we don't have that push-button tool, but we are able to do that."

The methods for shock-testing portfolios vary from simple to complex.

"If it is just an interest-rate move, you can mathematically calculate the impact of on a fixed-income bond because there is a formula to do that and you can string those formulas along and figure out what that portfolio is going to do," Dawal says. "It is much harder to do that on the equities side. Who is to say what role interest rates might pay at a company? Interest rates rising or declining at one company might have a different impact than on another company. It is not a purely mathematical kind of problem."

For situations such as this, a variety of firms provide data and services that help financial advisers pick apart hypothetical performance in broad strokes or granular pieces.

"These tools are all good at doing various things," Dawal says. "Then the art, if you will, is putting them together. There are companies out there that profess to be able to take a portfolio and run it through some statistical analysis that will give you that type of simulation. What they are giving you is generally going to be asset categories, unless they have the specific return-and-risk parameters for every security in the portfolio."

Admittedly, even a thorough stress test offers no crystal ball.

A big question, Dawal says, is "how is the individual investor or the institutional investor going to react in the face of these stresses?" The assessment may offer effective help when talking to a client about could happen, "but it doesn't talk about what will happen ... It may also assume that you are rebalancing your portfolio, but we know that some clients aren't going to do that. So these tools are based on some simplifying assumptions that are not going to be applicable for every investor."