How to Stress Test Your Portfolio Before the Next Market Shock

A portfolio stress test applies past market shocks, such as the Global Financial Crisis (GFC), to your current asset allocation to estimate how much your portfolio could fall. It is a simple way to check whether your strategy, diversification and cash buffer would hold up in a downturn. 

Investing is for the long term, but that doesn’t mean you shouldn’t know how short-term pressures might affect your portfolio. Understanding what a market shock could do to your returns or income can be invaluable in helping you adjust your strategy and build a resilient portfolio. It’s also something professional fund managers routinely do with the funds they offer. 

It might sound complicated, but it doesn’t have to be. 

Stress testing your portfolio involves taking a mix of scenarios from the past and seeing what they might mean for your portfolio today. Knowing how your portfolio might fare in a severe downturn can be reassuring as you head into volatile market conditions, and it can also prompt a useful review of your strategy and your needs. 

Key takeaways 

• Stress testing involves applying different market scenarios and events to your current asset allocation to see how your portfolio would perform.
  
  
• Historical market events, such as the GFC, are useful scenarios because each asset class has a recorded performance history you can apply. 
  
  
• If your portfolio no longer fits your strategy under a stress test, it’s an opportunity to revisit that strategy and consider your liquidity needs. 

What is portfolio stress testing? 

Portfolio stress testing is the process of applying a market scenario, real or hypothetical, to your current holdings to estimate the effect on your portfolio’s value or income. It answers a simple question: ‘If this happened again tomorrow, what would my portfolio look like?’ 

How do you choose stress-testing scenarios? 

Stress testing can be as simple or as detailed as you want to make it. Some investor tools allow you to enter hypothetical situations to show how your portfolio shifts, and if you work with a financial adviser, you can ask them to model what might happen. 

Otherwise, you could consider a range of scenarios inspired by the past and ask yourself how each would affect you. A good approach is to consider both market events and broader macroeconomic and financial system shocks. 

For example, you might consider how past events like these would affect your current portfolio: 

• the Global Financial Crisis (2007–2009) 
• a global health crisis, such as the COVID-19 pandemic 
• the 1994 bond market crisis 
• the 2022 global bond sell-off, when shares and bonds fell at the same time 
• an inflationary period with rising interest rates. 

You can pick as many scenarios as you like. The advantage of using past market events is that market data showing their impact on returns and values is readily available, so you can apply it to your current portfolio. 

How do you apply a scenario to your portfolio? 

Step 1: Break down your portfolio by asset class 

Start by identifying what proportion of your portfolio each asset class represents by value and, if relevant, by yield. You can also break the asset classes down further into Australian and global holdings, as the Australian market sometimes performs differently in specific asset classes. 

Step 2: Gather the scenario data 

Next, apply the market data for the scenario you want to test against each asset class. You can apply more than one scenario, but for simplicity, the example below uses only the GFC. The figures are approximate peak-to-trough movements over the crisis period. Not every asset class reached its low at the same time, so treat the result as a severe but illustrative estimate. 

*Later valuations showed that realised losses were considerably lower than this. Movements depend on the currency, index version and dates measured, so check the source data before applying them to your own portfolio. 

Step 3: Apply the movements to your allocation 

For this example, I’ve assumed a balanced portfolio of $500,000 with the asset allocation below. For simplicity, I’ve grouped asset classes rather than breaking them into Australian and global holdings. Australian assets performed differently: for example, Australian fixed income delivered better returns than US fixed income during the GFC, so your results would vary again if you broke the assets down further. 

Please note 

This is an illustrative example only. It is not a recommended portfolio or a guaranteed result. 

Under this scenario, the portfolio’s value would fall to $335,650, a loss of about 32.9%. 

What do the results tell you? 

This might sound alarming, but don’t forget that different assets recover in different ways and at different times. Reported private market valuations recovered faster than their listed equivalents after the GFC, partly because private assets are valued less often, which smooths out reported falls. By contrast, the MSCI World took nearly six years to return to its pre-GFC peak in US dollar price terms. 

Stress testing is also a good time to consider your liquidity needs and build a cash buffer if necessary. You only lock in a loss if you sell assets while the market is depressed, so consider what buffer would let you keep holding your investments and wait for a recovery, assuming the fundamentals still look sound and the assets continue to match your strategy and needs. 

Stress testing also clearly demonstrates the value of diversification. Had the whole portfolio been invested in shares, the loss at the market’s worst point would have been around 46%, compared with about 32.9% for the diversified portfolio. 

What other forms of stress testing are there? 

Stress testing doesn’t have to stop at extreme market events. You can also look at the impact of smaller shocks, and focus on your income rather than overall value if that is more relevant to your needs. 

Fund managers also consider volatility and other risk measures as part of their stress testing, often aiming to reduce how much a portfolio swings in value, even if that means accepting somewhat lower returns. 

What should you do after stress testing your portfolio? 

Stress testing can be a useful way to review your strategy, whether markets are rising or you think they may be facing pressure. 

The results can be reassuring or confronting, depending on your expectations and needs. You may choose to revisit your overall strategy or your liquidity buffer as a result. But if your strategy was built to meet your needs, circumstances and goals, and it continues to do so under stress-test scenarios, you shouldn’t need to make significant changes. 

If your portfolio falls apart under a stress test, that is usually a sign to review your strategy, and it can be valuable to discuss this with an expert. 

The key to resilience in challenging markets is planning ahead. Diversification remains important, and your liquidity needs should be part of your overall strategy. 

Frequently asked questions 

What is portfolio stress testing? 

Portfolio stress testing is the process of applying different market scenarios to your current portfolio to see how it would react and perform. Scenarios can be based on historical events, such as the Global Financial Crisis, or on hypothetical shocks, such as an oil crisis. 

How is stress testing different from a risk review? 

A risk review looks at typical market behaviour, such as the volatility and standard deviation of your portfolio’s returns over time. A stress test looks at what would happen in extreme market conditions. 

How often should you stress test your portfolio? 

A good time to stress test is whenever you review your portfolio, which for most investors is once a year. You should also consider a stress test after any significant life change, such as retirement, a new job or an inheritance. 

What should you do if your portfolio no longer fits your strategy under a stress test? 

Use it as an opportunity to revisit the asset allocation of your portfolio, check that it is still appropriate for your strategy, and consider whether certain allocations need to change. You may also consider whether you need a liquidity buffer to support your strategy in extreme market conditions. It can be valuable to do this with an expert, such as a financial adviser.

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.