Stress test your portfolio in seconds

UPDATE AUGUST 2018: I have now updated the asset allocation tool to take into account two new scenarios which occurred in 2018, as described at the foot of this article

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.

When equity markets are at or near all-time highs the potential for a market fall is increasingly likely. Some of the largest investment banks and financial institutions will perform stress test scenarios to see how assets or markets will 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 a technology stock crash? 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 2,100 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 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 Chinese economic growth 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 UK All Companies Sector is not comparable to a 5 star rating from the Europe excluding UK sector. It also means that a technology fund can receive a 5 star rating in the 'tech sell-off' 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 tech sell-off you wouldn't invest in a technology fund in the first place, so it is more useful to find out the tech funds that fare better in a tech 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 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 funds 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.

Negative Periods

While the above measures focused on the short term this measure focuses on the last 3 years. It measures the number of months where a fund lost money. The lower the downside protection the more prone the fund is to periods of negative returns.

The next four factors are specific scenario stress tests. Each scenario occurred in recent years and represent the occasions when equity markets usually fell by more than 10%. The nature of each scenario is slightly different which gives the ability to assess how each fund performed versus its peers within the same sector during a given scenario and therefore how the fund may perform in the future under stress.

China worry

In August 2015 the market fell over 11% when everybody suddenly became worried that China's economy was slowing rapidly and that global growth was stuttering. This stress test gives insight into how a fund might perform, compared to its peers from the same sector, if concerns over Chinese or global economic growth panics the market again. Remember that a Chinese equity fund could receive a 5 star rating which means it held up better than other Chinese equity funds but it will still have fallen in value.

Bank sector worries

2016 got off to a dismal start culminating in the market becoming concerned that a new banking crisis was imminent. The market again fell by more than 12%. This stress test indicates how the fund may perform versus others in its sector if a new banking crisis emerges.

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.

Tech crunch

The equity rally of the last 2 years has been largely driven by surging share prices in technology companies such as Facebook. At the end of March 2018 technology stocks fell by 5-6% in a matter of days which unsettled the market. While the wobble settled down there are signs that we could see a future technology stock collapse which could drive the market lower. This stress test looks at how a fund might underperform or outperform its peers from the same sector if we get a full tech crunch.

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'. 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 the first three 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.

 

(Photo by num_skyman via freedigitalphotos.net)