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STA Wealth Management – Portfolio Stress Test

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STA Wealth Management – Portfolio Stress Test
By Scott Bishop, MBA, CPA/PFS, CFP®
Executive VP of Financial Planning

Although the markets have had a nice run since bottoming in March of 2009 (after the 2008 Global Crisis – see chart below), many are feeling that they are due for a correction based on time, valuations, “headline” risks, etc.  Even if your portfolio had a nice run in recent years, we believe markets will eventually correct. Historically we have had on average a 10% market correction every 2 years.  As we are almost nine years into this “bull market”, we wanted to help with a reality check and share how your portfolio might react in the event similar “bear market” factors that took investors decades to recover from were to reemerge.  I wrote about these risks in two articles for CNBC in 2014:

Historical Market Cycles

STA Wealth Portfolio Analysis

When reviewing portfolios, our team at STA Wealth uses analytical tools available from sources such as Bloomberg, Morningstar and S&P Capital IQ, to name a few. In addition, we provide specific insights from our Investment and Financial Planning teams by reviewing your current portfolio’s strengths and weaknesses given the market cycle, portfolio design, tax issues and account types/structure. Doing this allows us to determine whether your portfolio is aligned and optimized to meet your personal financial planning goals and objectives (goals such as knowing your  Hurdle Rate).

STA Wealth – Portfolio Stress Test

After sharing our analysis as outlined above, we perform a Portfolio Stress Test that is specific and unique to your portfolio given your current holdings. Using this information, we are able to use Bloomberg’s multi-factor based risk model to analyze and determine how your portfolio might be impacted if we see a repeat of several historical scenarios that caused market losses.

The table below illustrates the output of a recent scenario analysis we conducted for someone’s portfolio. While the portfolio has done well in recent years, the analysis indicates that the portfolio might be subject to significant percentage and dollar losses if past market environments were to repeat.

Please Note: The scenario analysis P&L is gross of fees and only accounts for the performance of liquid public securities held in the portfolio. The P&L impact is based on portfolio exposures to factor volatility and assumes that the covariance matrix fully determines the relationship between independent and dependent variables. Additionally, a small amount of shrinkage is made to the correlation matrix to improve the robustness of the inversion operation required to propagate stress across asset classes.

As you can see, quite a bit of positive portfolio performance can be wiped away in the event of a market event like those we have lived through in just the most recent nine years. This volatility can cause significant “money worries”. Although losses can be made back over time IF you stick to your investment discipline (assuming the market recovers), our experience has shown us that many investors flee the market and “go to cash” during times of crisis.

Investor Behaviors and Biases

As we mentioned above, during times of stress, many investors (and even many investment advisors) make the mistake of NOT sticking to their investment discipline.

At STA Wealth, we believe that the two greatest attributes any investor or advisor can have are a written and defined discipline and a plan of action. Without either of those you may find yourself subject to a vicious journey like this:

Source: Stock Twits Blog

Historical Stock Market Corrections

Over the last several years, we have not had a market correction.  As shown in the stress test above, portfolios are subject to large losses, if not hedged and/or diversified properly. Risk does happen, has happened and will continue to happen in the markets.

As it has been a while since the last correction, it is important to remember corrections in recent history (many of which you may have personally experienced).  Pictured below is a quick recap of the major double-digit Dow Jones Industrial Average drawdowns in price since 1986, measured from intraday high to intraday low. Nearly every drop has been blamed on either rising interest rates (changing discount rates on business earnings), fears/reality of slowing economic activity, or both.

Market Corrections since 1986

Bottom line

If you want to better assure that that your portfolio can weather the next market correction, make sure you can answer these questions:

  1. Do you have an investment discipline that you will be able to stick to it if one of the stress test scenarios repeats? Follow this link to the webinar on STA Wealth’s investment discipline.
  2. Have you thought in ADVANCE how you should invest rationally given the age of the current bull market? Follow this link to our webinar on investing in an aging bull market.

Scenario Analysis Legend

  • Equity Markets Rebound in 2009: Global equity markets rebound following 2008 drawdown. Time frame: 3/04/2009 – 6/1/2009
  • Greece Financial Crisis 2015: Athens’s resistance via referendum and ultimately agreement to rush through long-resisted economic reforms, imposed by its creditors, in a bid to stay in the eurozone. Timeframe: 6/22/2015 – 7/8/2015.
  • Libya Oil Shock February 2011: Civil war in Libya breaks out on February 15th 2011, causing oil prices to surge. Timeframe: 2/15/2011 – 2/23/2011.
  • Oil Prices Drop May 2010: The price of oil drops 20% due to concerns over how European countries would reduce budget deficits in the wake of the European economic crisis. Timeframe: 5/3/2010 – 5/25/2010.
  • Japan Earthquake in Market 2011: On March 11th a 9.0 magnitude earthquake occurred off the coast of Japan which also triggered a major tsunami. Timeframe: 3/9/2011 – 3/15/2011.
  • Debt Ceiling Crisis & Downgrade in 2011: Debt ceiling crisis that led to USA credit downgrade. This stress scenario describes a 17 day period starting from 7/22/2011 when market began to react to debt ceiling impasse. 8/8/2011 is the first business day after downgrade announcement. Timeframe: 07/22/2011-08/08/2011.
  • Equities down 10%: Global/US/Europe/Asia & Japan market factors down 10% and propagate shock correlations defined within the Bloomberg Factor Models.
  • EUR up 10% vs. USD: EUR up 10% vs. USD, propagated to other currencies and equity factors via correlation.
  • Lehman Default 2008: Historical returns over the month immediately following default of Lehman Brothers in 2008. Timeframe: 09/14/2008-10/14/2008.
  • EUR down 10% vs. USD: EUR down 10% vs. USD, propagated to other currencies and equity factors via correlation.
  • Equities up 10%: Global/US/Europe/Asia & Japan market factors up 10% and propagate shock using correlations defined within the Bloomberg Factor Models.
  • Russian Financial Crisis 2008: War with Georgia and rapidly declining oil prices raise fears of an economic recession within the region. Use Historical risk factor returns from 08/07/2008-11/20/2008.

Explanation of Stress Test Scenarios Used in Our Portfolio Analysis:

  • Russian Financial Crisis (2008): War with Georgia and rapidly declining oil prices raise fears of an economic recession within the region.
  • Lehman Default (2008): Historical returns over the month immediately following the default of Lehman Brothers in 2008.
  • S&P 500 down 20%: Simulates a 20% drawdown on the S&P 500
  • Debt Ceiling Crisis & Downgrade in 2011: Debt ceiling crisis that led to USA credit downgrade. This stress scenario describes a 17-day period starting from 7/22/2011 when the market began to react to debt ceiling impasse. 8/8/2011 is the first business day after the downgrade announcement was made.
  • Equities down 10%: Global/US/European/Asia & Japan market factors down 10% and propagate shock correlations.
  • Oil Prices Drop in May 2010: The price of oil drops 20% due to concerns over how European countries would reduce budget deficits in the wake of the European economic crisis.
  • Greece Financial Crisis (2015): Athens’s resistance via referendum and ultimately agreement to rush through long-resisted economic reforms, imposed by its creditors, in a bid to stay in the Eurozone.
  • Keep in mind that the scenario analysis P&L is gross of fees and only accounts for the performance of liquid public securities held in the portfolio. The P&L impact is based on portfolio exposures to factor volatility and assumes that the covariance matrix fully determines the relationship between independent and dependent variables. Additionally, a small amount of shrinkage is made to the correlation matrix to improve the robustness of the inversion operation required to propagate stress across asset classes.


Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

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