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Portfolio stress testing is a key tool in understanding risk and potential blind spots in periods of market turmoil. Clarity enables the user to stress test their portfolio via a diverse set of analytics including Monte-Carlo simulation and user-defined factor-based scenarios.
The Importance of Stress Testing
Often investors are surprised by the degree of losses they experience during periods of market turmoil. We believe that there are two primary reasons for this. First, a failure of imagination as to the cause and magnitude of the market stress event that occurs. Recent examples include the 2008 financial crisis instigated by the meltdown in subprime mortgages and the 2020 once-in-a-century global pandemic. Second, an inability to properly calculate the impact of such events on their portfolio.
The impact of inadequate stress testing is significant. Investors may take excessive risk during normal times only to need to reduce sharply (or undergo forced liquidation) in periods of market turmoil. Alternatively, they may miss opportunities as they are unable to properly quantify risk and act as a "deer in the headlights".
Stress Testing in Clarity
Clarity provides multiple tools for running stress testing on a portfolio.
The first is user-defined stress tests where and investor can specify either a period of time (i.e. March 2020) or a set of factor and idiosyncratic shifts and calculate what the impact of their portfolio would be.
A second approach is to revalue the portfolio on a given date in the past to see what the P/L impact would be.
A third way is to run a Monte-Carlo simulation. This has the benefit of an being an unbiased set of scenarios.
Understanding Results
In risk there is typically not a "single number" that explains everything. This is one of the weaknesses of the value-at-risk (VAR) methodology. By having various stress test measures, an investor can triangulate amongst them to get more confidence in the results. In the example above, the worst case loss in the simulation ($9.7mio) corresponds closely to the SPY crash scenario (-40%) of down $10mio.
