The Essential Value of Portfolio Stress Testing

Improvising a stress test helps an investor in identifying the risk factors affecting a portfolio and positions themselves in such a way so as to mitigate the identified risks.

Improvising a stress test helps an investor in identifying the risk factors affecting a portfolio and positions themselves in such a way so as to mitigate the identified risks. Portfolio stress testing seeks to study the adverse effects of financial downturns, loss strategies and to strengthen the business under varying economic climates.Stress testing involves analyzing the impact of various risk factors in one’s portfolio and estimate the potential loss to a portfolio under adverse economic circumstances. There are methods and strategies to apply this technique and let us see what they are:

Historical Stress Testing:

Historical stress testing is intended to gauge the health of a portfolio. The portfolio manager identifies an adverse event that has occurred in the past and has affected the economy as a whole. An example of this could be the Sub-Prime Crisis or the 9/11 attacks. After identifying an event, the portfolio manager then proceeds to apply the same to his portfolio and gauges the impact of the same on his portfolio. The main advantage of using the historical method is that the events identified under this method have actually taken place at some time in the past. However, care must be taken to identify and use such historical events which would have relevance to the portfolio in question.

Customized Stress Testing:

Whether an event that has taken place is the past is likely to recur or not remains unknown. As such, the historical stress testing may actually be for a scenario which may never occur in the future. Besides, new financial instruments are developed which get added to one’s portfolio. As such, the use of historical stress testing may not be appropriate since in the past these new financial instruments would not have existed. To overcome these limitations, Customized portfolio stress testing is used. These are tailor-made to assess the impact of risk factors if some specific adverse event were to happen. These tests are generally developed in relation to those scenarios which are likely to have a material impact on the portfolio.

Reverse Stress Testing:

Historical tests and Customized tests indicate the potential loss suffered if an adverse event pans out. They give an estimate of the loss on an adverse event materializing. Reverse testing on the other hand tries to arrive at an event that would lead to the failure of an organization on the whole. Reverse testing involves identifying the risks involved in a possible course of action that would lead an organization to its doom.  However, reverse tests involve a lot of thought process and since they begin from the scratch and seek to identify the roots of the problem, they are often construed to be very laborious.

Portfolio stress testing is essential to the banking sector to estimate the risks involved in the portfolio of the advances held by  the bank and seeks to capture the risks to the various asset classes comprised in the portfolio in case of economic adversities. 

CRE Portfolio Stress Testing - CEIS can assist in creating an effective and manageable stress testing process and framework.

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Portfolio Management Techniques Decoded

A portfolio is an assortment of various stocks, a collection of various financial assets. Portfolio Management refers to managing them professionally in such a manner as to multiply the assets while considering the risk tolerance and the objectives of the investors. The strengths, weaknesses, opportunities and threats as well as the risk level need to be considered while investments are made.

A portfolio is an assortment of various stocks, a collection of various financial assets. Portfolio Management refers to managing them professionally in such a manner as to multiply the assets while considering the risk tolerance and the objectives of the investors. The strengths, weaknesses, opportunities and threats as well as the risk level need to be considered while investments are made. It is one of the major branches of finance and there are various professional courses catering to the study of portfolio management and it is a major line of study for people pursuing finance as a career.

The various methods to maximize the return at a given risk quotient are referred to as Portfolio Management Techniques. These techniques focus on achieving a balance between growth and stability. They involve assessing the performance of the portfolio based on risks and also a benchmark that has been set for the same. Diversification of the portfolio, risk measurement, asset pricing and risk-return trade-off, etc have  to be kept in mind while managing a portfolio. It is however very difficult to manage a portfolio and reap benefits as desired during tough economic conditions for a portfolio manager. Generating good returns in volatile markets with minimal risks (investors would be opposed to taking major risks under volatile market conditions) is a difficult task indeed for the managers of the portfolio.

Various Portfolio Management Techniques

The various Portfolio Management Techniques are – Heuristic models, scoring techniques and visual or mapping techniques. Scoring techniques are used to increase the profitability and find the exact investment needs. Simple Additive Weighting and Weight Product Method are the two commonly used methods of scoring techniques.

Scoring Techniques

Scoring techniques involve identifying non-monetary attributes that have an impact on the returns and allocating some weights to these attributes based on their importance. However, since we use historic samples to arrive at the factors and their weights, the sample should be large enough and accurate. They assist a portfolio manager in identifying risks and taking appropriate measures.

Visual or Mapping Techniques

Visual or mapping techniques employ graphic representations to depict the balance of the portfolio using two or more criteria. These criteria can be viewed as the dimensions of the graph or the pictorial representation. For instance, the most commonly and widely used portfolio diagram is a representation of probability of success vs. reward. A bubble diagram is a popular way of representation. A circle or ellipse is drawn for identification of each project and information can be depicted using the shape of the circle, shading a region, etc.

Portfolio Planning Matrix

Portfolio Planning Matrix is a tool used by the various large companies to manage the assets/ portfolio of their strategic business units. The matrix represents the growth opportunities and market share.

Till date, various new techniques and strategies have been developed to assess and measure risks while maximizing the return for the investors. This field of study and business is under constant innovation and is a main stay of a company’s profitability.

Portfolio Management Techniques by CEIS Review, For more information visit us at http://www.ceisreview.com/pages/Services/2/105/CRE_Portfolio_Stress_Testing