RiskMetrics - Stress testing


Stress testing

Understand how to stress test your portfolio for abnormal markets

While risk statistics work well for estimating risk during normal market conditions, they cannot predict the occasional, unexpected crises that result in extreme market shocks. To address this issue, we recommend stress testing.


Historical Events

RiskMetrics research has identified historical stress scenarios that have resulted in the largest losses for a diversified global portfolio consisting of 60% equities and 40% fixed income. The following historical scenarios resulted in the largest one- and five-day portfolio losses:

RiskMetrics research has identified historical stress scenarios that have resulted in the largest losses for a diversified global portfolio consisting of 60% equities and 40% fixed income. The following historical scenarios resulted in the largest one- and five-day portfolio losses:

Crisis Date 1-day loss 5-day loss
Black Monday 19-Oct-87 -2.2% -5.9%
Gulf War 3-Aug-90 -0.9% -3.8%
Mex Peso Fallout 23-Jan-95 -1.0% -2.7%
Asian Crisis 27-Oct-97 -1.9% -3.6%
Russia Devaluation 27-Aug-98 -3.8% -2.6%

Many investors, including professional money managers, lost much more money during these days because their portfolios were not as well diversified. For example, the once-famed LTCM hedge fund, lost over 80% of its value during the '98 Russia Devaluation, because of excessive leverage and overconcentration.

Stress your portfolio

These events highlight the importance of stress testing your portfolio to get an idea of how badly things could go during a crisis and to assure that losses do not exceed your loss-tolerance level. Similar to stress testing buildings and bridges under extreme environmental conditions, investors should stress test their portfolio to see if it can withstand adverse market conditions.

Two basic approaches

The basic question stress testing seeks to address is: "how much could I lose during a crisis event?" There are two basic ways to go about answering this question. The first is historical stress testing, which estimates how your portfolio would fare if you relived past events, such as the '87 stock market crash. The second approach is to invent your own extreme scenario based on what you think might go wrong in the world. The difficulty with these approaches is that (a) history is unlikely to repeat itself, and that (b) we don't have a crystal ball for predicting the future. Nonetheless, the discipline of stress testing allows you to consider your tolerance for loss and provides reference points for how bad things could get.


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