Stress Testing – Holistic Planning should consider both Micro and Macro

By Jeff Baker, HiddenLevers on Tuesday, September 22nd, 2015

 
 


Stress testing used to be reserved for large banks and top tier asset managers. Now advisors are turning to stress testing to differentiate themselves against a backdrop of increasing commoditization in the asset management industry. Today, holistic planners need to provide both custom financial plans and risk analysis tailored to a client’s concerns. Scenario-based stress testing allows financial advisors to do exactly that.
 
Helping clients understand their own capacity for risk
For most advisors, integrating stress testing into holistic planning starts with understanding their client or prospect’s tolerance for risk. A holistically minded advisor will help a client acknowledge their own loss tolerance and create a plan around it. Risk tolerance questionnaires (RTQs) can help enable clients and prospects to assess their own psychological capacity for risk. RTQs are unique in that they can be completed without advisor input, allowing a client to record their own feelings about portfolio losses and risk.
 
What does risk look like?
 A risk-minded financial planner can take a client-generated loss tolerance number and add color through scenario-based stress testing. Scenarios like China Slowdown and Fed Rate Hike allow an advisor to go beyond traditional (read: inaccessible) risk metrics and introduce a range of events that are likely to cause a violation of that loss tolerance number.
 
Unfortunately, many advisors have relied on antiquated risk analytics  to test loss tolerance.  A Monte Carlo approach could show a client losing 15% over the next 6 months, when in fact the true tail risk is 30% or more. Unfortunately, markets skew toward extremes, and investors have learned the hard way that rare downside events actually occur every 6-10 years. Scenario-based stress testing can help advisors model these downside risks, and clarify loss tolerance with real world stress test results.
 
Stress testing also enables the advisor to address specific macro concerns. Holistic planners have long known how to give character to a specific personal goal – the micro. Now scenario-based stress testing helps advisors give character to big picture concerns – the macro. Advisors can illustrate how a portfolio reacts to a commodities crash or housing rebound.
 
Stress testing becomes the new standard
Advisors who have adopted stress testing will not only find themselves better qualified to provide holistic planning advice but will be ahead of an increasingly strict regulatory regime. Earlier this year the SEC hinted at required stress tests for all mutual funds and SMAs, increasing the focus on risk for asset managers. Holistic planners who have foreseen these changes have welcomed the scrutiny. “Many advisors have seen the writing on the wall” says Raj Udeshi, co-founder of the stress testing platform HiddenLevers, “We have had unprecedented demand for stress testing in the past year, we expect that to continue as advisors focus on better ways to address risk and meet their fiduciary duty.”
 
 
Jeff Baker is a member of HiddenLevers, an interactive stress testing and risk platform based out of New York. HiddenLevers works with financial advisors, holistic planners, broker dealers, and asset managers to stress test investment portfolios and optimize return outcomes.
 
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