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Portfolio Stress Test

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

In November of 2017, I wrote the article suggesting that it may be time for you to perform a “Portfolio Stress Test”.  Many of our newsletter readers were a little worried that the Bull Market run was getting ahead of itself, and I was suggesting that there was no better time than during a bull run to review your portfolio strategy and susceptibility to market risk and volatility…Similar to how you would rather have a treadmill stress test to check your heart health BEFORE you have a heart attack.

In the last few days, the market has erased all the gains for 2018.  If that makes you nervous or worried, do not make a decision to “sell and go to cash” based on emotion.  Get some data to make an informed decision.  You should ask yourself these questions:

  1. Is my portfolio keeping me up at night?
  2. Do I feel that portfolio is being managed optimally?
  3. If it goes down further, can I handle it? (both emotionally and in terms of your financial plan)
  4. Will a market correction derail my retirement? (check out our Retirement Survival Guide to see more on this)
  5. Do I have any tools or components in my portfolio or portfolio management strategy to reduce or mitigate risk if the markets start falling fast?

If you don’t know the answer, I would suggest that it is time to review your strategy or at least get a stress test to see how it will react if this negative market trend continues.  During one of the recent market pull-backs in 2014, I was asked by CNBC to write two articles that may be worth revisiting now:

 

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.

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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