Stress Testing Your Portfolio

Today I want to talk about why stress testing your portfolio is so important. Like many investors, you’ve probably built your investment portfolio with the goal of maximizing your returns. But have you considered the risks? When the markets are booming–like they did in 2013 when the S&P 500 was up 32.39% including dividends (Source: YCharts)–investors often forget about the very real risks posed by investing in often volatile investments. And when we have extended bull markets like we’ve seen recently (the S&P 500 nearly doubled in value between March of 2009 and June of 2015) it’s easy to lose sight of the fact that markets can and do decline in value–often very rapidly.

What is stress testing?

Simply put, stress testing is the process of evaluating how something performs under extreme or adverse conditions. So, if we were going to stress test a new fishing pole designed for fishing 5 pound trout out of a lake, we might put it through it paces to see how it holds up pulling 6 or 7 pound objects out of the water. If it holds up and doesn’t snap during the stress test, we can be pretty sure it won’t break hauling those 5 pounders into the boat! You get the idea.

Fortunately, we don’t have to wait for markets to crash in order to stress test your portfolio! We can use software to look at simulated results instead. By looking back at how an investment or a portfolio of investments would have performed during prior periods of financial turmoil (the tech bubble bursting, the subprime mortgage crisis, etc.) we can estimate how they might perform in a future situation.

Why do we stress test?

Benjamin Graham said it best. “The essence of investment is management of risk, not management of returns.” For a lot of reasons I’m not going to go into here (and, which by the way, are probably very obvious to my readers) we want to avoid taking losses! Stress testing a portfolio gives us an idea of how our investments might respond in the future should a crisis occur. And this gives us the ability to modify a portfolio to balance a client’s goals with their tolerance for risk.

Risk Metrics and Stress Testing Your Portfolio

We have at our disposal a wide variety of tools and metrics that we can use to measure and quantify investment portfolio risk. Many of these metrics seek to compare an investment’s risk against that of an underlying index or benchmark (Beta, Sharpe Ratio, Sortino Ratio, Treynor Ratio, etc.). And while this is useful for me as an investment advisor (in the investment selection process), many of these metrics are abstract and subject to interpretation. That means they are often not useful for communicating with investors who might not have a sophisticated understanding of the statistics involved.

There is one measure, however, that I find is both informative and easy to communicate: maximum drawdown. Investopedia defines “maximum drawdown” like this:

The maximum loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum Drawdown (MDD) is an indicator of downside risk over a specified time period. It can be used both as a stand-alone measure or as an input into other metrics such as “Return over Maximum Drawdown” and Calmar Ratio. Maximum Drawdown is expressed in percentage terms and computed as: (Trough Value — Peak Value) ÷ Peak Value.

Here is an example:

This is a chart of the performance of a client’s portfolio before I started managing it. Note the period between 10/31/2007 and 3/9/3009. This portfolio lost 45.9% of it’s value. This means a $1 million portfolio on Halloween on 2007 was only worth $542,000 on March 9th, 2009. Ouch. Note also that this portfolio took 781 days to recover back to it’s original value. That’s a little over two years. Ouch again.

Why is this so important?

When I run this analysis for new clients before we begin to transition their portfolios over, this chart often sparks a discussion about just how much (or little) risk tolerance they have. I’ll ask if they could withstand a 45% decline in the value of their retirement account if it happened again today. Because it could. Financially, many could ride through the downturn. Emotionally? Well, that’s another question.

Here’s the thing: Markets go up and markets go down. That’s called volatility. And volatility is the price we all pay for long-term returns. But we have to balance our capacity for this volatility with our needs and our goals. Stress testing your portfolio by looking at the maximum drawdown over the past 20 years or so can give you some important information as you answer this question for yourself.