Stress test your portfolio in seconds – 2022 Update

UPDATE August 2022: I have now updated the stress test tool to take into account a new scenario, as described in full at the foot of this article. The new scenario looks at what would happen if the US entered a recession (dragging the rest of the world with it) as a result of overly aggressive policy tightening (i.e. raising interest rates) from central banks. 

Investors, be they professional or DIY investors, don't give enough consideration to the downside potential of their portfolios. When engineers build a new skyscraper they don't just focus on reaching for the stars. In fact, they pay more attention to the structure's ability to remain upright. How will the structure cope in high winds or an earthquake? How much weight can it hold per square inch? This stress testing of materials and construction ultimately lays the foundation for the success of the project.

Building an investment portfolio shouldn't be any different. The trouble is that investors are always aiming for the stars and pay less attention to what will happen in times of market stress. Let's say the market fell by over 10% how would your portfolio fare? Bear in mind that if a portfolio falls by 50% it has to grow by 100% to just get back to where it started.

Some of the largest investment banks and financial institutions perform stress tests for different scenarios to see how assets or markets might hold up. Don't forget the entire European banking system has undergone a number of stress tests to see how it would fare in another credit crisis.

Yet it has been impossible for DIY investors to stress test their portfolios in the same way. How can they test to see how their portfolio might react if global growth concerns rear their heads, or if we get an escalation in the US-China trade war? How can they gauge how their portfolio will fare in an unknown Black Swan event?

In my previous research I have explained a number of ways you might protect your portfolio from certain events, such as a banking crisis. This has involved looking at key fund statistics and/or fund performance during similar conditions. Yet I've now taken this one step further and built a tool that can stress test any portfolio (and over 2,000 funds) in seconds. A tool which 80-20 Investor members can download and keep at no extra cost.

How to stress test your portfolio

The tool is useful for those trying to decide between unit trust funds within the same sector. So you may decide that you want to invest in Chinese equities but want a fund which will fare better than its peers from the same sector if US-Chinese trade war concerns re-emerge.

To achieve this the tool focuses on key measures which when combined show how a fund might perform under periods of stress. In each area a fund is awarded between 1 and 5 stars based on a number of factors outlined below. The important point to note is that a rating is applied by comparing a fund to its peers from the same sector. So a 5 star rating in the UK All Companies Sector is not comparable to a 5 star rating from the Europe excluding UK sector. It also means that a China fund can receive a 5 star rating in the 'Trade war escalation' scenario as it indicates that the fund will likely fare better than its peers from the same sector, even though it will still likely lose money. The reason that the ratings are sector-specific is that if you were worried about a China-led sell-off you wouldn't invest in a China fund in the first place, so it is more useful to find out the China funds that fare better in a China sell-off especially if you are following momentum.

Sharpe Ratio

The Sharpe Ratio is a measure of the excess return a manager is achieving for the risk they are taking. Therefore a fund which I've awarded 5 stars for its Sharpe Ratio takes more calculated risks and produces stronger returns for the risk being taken than other funds within the same sector. A fund with a 1 star rating will likely take excess risk for its investors and therefore is likely to struggle if markets fall versus its peers within the same sector.

Sortino Ratio

This is very similar to the Sharpe Ratio but places more emphasis on the manager's ability to manage on the downside.

Volatility

This is a measure of a fund's dispersion of returns, or in plain English the variability in those returns. Think of it as a measure of how much a building is prone to wobble. The more prone it is (the higher the volatility) the more it will sway in an earthquake. Again this is relative to the sector that the fund belongs to. So a 1 star rating on a bond fund would suggest it is volatile for a bond fund but it does not mean that it is more volatile than an equity fund with a 5 star rating. Clearly an equity fund will always be more volatile than a bond fund. That's why the ratings are sector-specific.

Volatility spike and bond wobble

Equity markets hit an all-time high in January 2018 at the same time that market volatility (or fear) hit historic lows. A sudden panic over rising inflation sent bond yields spiking higher amid fears that the bond bull market was about to collapse. This sparked a bond sell-off which in turn sparked an equity market correction across the globe. Stock markets globally fell by at least 10% and it represented the first stock market correction in 2 years in the developed world. This stress test looks at how a fund might outperform or underperform its peers from within the same sector if we see another spike in bond yields and equity volatility like we saw in the spring of 2018. It also gives a good indication how a fund might fare in an environment when bonds and equities fall in tandem.

Trade war escalation

With the US and China embroiled in an on/off trade war the impact on global economic growth continues to make investment markets nervous. With the tit-for-tat nature of the trade war threats there are clear winners and losers from an investment perspective (both on a sector level and an asset level). This stress test focuses on May 2019 when Donald Trump unexpectedly escalated the trade war which shook investment markets. This stress test looks at how a fund might underperform or outperform its peers from the same sector if the US-China trade war reignites/escalates or relations between the two superpowers sour.

Pandemic / depression

The coronavirus pandemic of 2020 abruptly brought to a halt one of the longest bull markets in history. The pandemic sparked the fastest bear market on record with most major stock market indices falling 30-40% in a matter of weeks. Investment markets and investors' portfolios were placed under the greatest strain in decades. But it is the impact on economic growth and corporate profits as well as the possibility of a recession turning into a deep depression that this scenario also stress tests. This stress test looks at how a fund might underperform or outperform its peers from the same sector if a pandemic hits, or if we encounter an unexpected slump in economic growth of historic proportions.

Reflation / Value outperforms

Following the creation of a COVID-19 vaccine and the implementation of a vaccination programme in Europe, the US and the UK, economic growth rebounded strongly in 2021. The US Federal Reserve and other central banks were initially cautious about raising interest rates and removing the monetary stimulus that supported economic growth during the pandemic. Early signs of rising prices, and a lack of central bank intervention, caused investment markets to rapidly price in a significant rise in future inflation resulting in a large disparity in performance between different asset classes and investment funds. We saw a significant rotation out of growth stocks into value/cyclical stocks. That was the biggest difference between this scenario and the "Volatility Spike / Bond Wobble". In the reflation trade the market was pricing in further economic growth and stock markets remained at all time highs, while bond yields stabilised after an initial rally. Volatility was also contained in 2021. Interestingly when equity market volatility picked up and inflation spiked, along with bond yields, in early 2022 we moved into the "Volatility Spike / Bond Wobble" scenario. The reflation/value scenario is a good test of what would happen during a period of strong economic growth and rising inflation, but also which funds would fare better in an environment where value outperforms growth.

Recession / aggressive Fed tightening

In the summer of 2022 the US Federal Reserve (the Fed) and other central banks continued to aggressively tighten monetary policy (i.e. raising interest rate) to try and control multi-decade high inflation. However investors started to become worried that such an aggressive policy stance would tip the US and other economies into a recession, given that there were already signs that high inflation was impacting consumer and business spending. In June/July 2022 bond markets began rapidly pricing in a recession and investors started rotating into defensive equity sectors. This is a good test to see how a fund may react versus its peers if the market suddenly starts pricing in a potential recession or how a fund may fare if we enter a recession.

How to use the stress tool

First of all download the Portfolio Stress Test tool (click enable macros when it opens). Then simply select the funds in your portfolio by clicking on the arrows that appear when you select one of the greyed out cells in column 'a' of the "Tool" tab. You can scroll more quickly through the list of funds by using your keyboard. On a mac you can use Fn+Cmd+(down arrow). Unfortunately, I don't know the keyboard shortcuts on a Windows PC so you will have to experiment. If you use the keys you have to select a fund by hitting enter.

If you choose a fund such as Fundsmith Equity you will see that it is in the Global sector. That means all the star ratings for each factor are in relation to the fund's global sector peers. To help scan across quickly the cells change colour with green being awarded to 5 stars and red for a 1 star. For numbers in between the colour ranges between the two.

So you are looking for cells to be as green as possible. That would indicate that the fund passes the stress test versus its peer group. In the final column is an average score across all factors so giving a fund a star rating out of 5 for its sector.

The tool can take up to 20 funds and then give your portfolio an overall stress test rating out of 5. The tool deliberately doesn't focus on performance (the 80-20 algorithm and fund shortlists provide that) as it is all about testing the robustness of your fund choices. While we can't predict a Black Swan event a number of the above scenarios were akin to Black Swans at the time they occurred. Therefore a fund that gets a strong rating in each would hopefully fare better in the event of an unknown Black Swan event than a portfolio with the same asset mix.

Please note that past versions of the stress test tool that include other older scenarios can be found in the research & insight section of 80-20 Investor.

(Photo by num_skyman via freedigitalphotos.net)