What is an investment stress test?

What is an investment stress test

Stress testing and your investments

Stress testing (sometimes called torture testing) is a form of deliberately intense or thorough testing used to determine the stability of a given system, critical infrastructure, or entity. It involves testing beyond normal operational capacity, often to a breaking point, to observe the results.

Stress tests are used in many fields:

  • The most well-known might be a fitness stress test, also known as an exercise test or treadmill test, can give an idea of how well a person’s heart works during physical activity. It can also help diagnose various heart conditions.
  • In engineering, there’s a thing called a “hydrostatic stress test,” where they take pipes or fuel tanks or ship parts or whatever and they pump tons of water into them. The intense pressure from the water then exposes leaks and weaknesses in the structure, showing the engineers where the vulnerabilities are.

Covid has been a stress test of sorts

Covid-19 has been a kind of stress test for each place and each person around the world.

  • Each system’s weakness has been revealed. Countries overburdened with regulations have been punished for their overregulation. Countries that have a penchant for authoritarian and/or incompetent leaders have had those leaders exposed. And countries that have factious, distrustful cultures have paid the price for their divisive ways.
  • This stress test has occurred within our individual lives too. Couples that had been burying their problems for years quickly had them exposed. Weak and opportunistic friendships got washed out. Fragile careers were broken. Miserable lifestyles replaced. Bad TV shows were deleted.

But the stress test of hardship doesn’t just expose weakness, it also reinforces strength. Good relationships become better. Important decisions get made. Priorities get straightened out.

Investment stress testing

Stress testing involves running simulations to identify hidden vulnerabilities.

When it comes to investing, stress testing is a computer simulation technique used to test investment portfolios against possible future financial situations. Such testing is customarily used by the financial industry to help gauge investment risk and the suitability of investment assets. It can also help evaluate internal processes and controls.

In recent years, regulators have also required financial institutions to carry out stress tests to ensure their financial strength and suitability.

Stress tests can use historical, hypothetical, or simulated scenarios.

Historical stress testing

In a historical scenario, the asset class, portfolio, or individual investment is run through a simulation based on a previous crisis. Examples of historical crises include the stock market crash of October 1987, the Asian crisis of 1997, and the tech bubble that burst in 1999-2000.

Hypothetical stress testing

A hypothetical stress test is generally more specific, often focusing on how a particular company or investment might survive a particular crisis. For example, a firm in New Zealand might stress-test against a hypothetical earthquake, or company that relies on oil might do so against the outbreak of war in the Middle East.

Stylised scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. For example, the stress test might involve a major investment index losing 10% of its value in a week.

Simulated stress testing

As for the methodology for stress tests, a Monte Carlo simulation is one of the most widely known. This type of stress testing can be used for modeling probabilities of various outcomes given specific variables. Factors considered in the Monte Carlo simulation, for example, often include various economic assumptions and inputs.

Companies can also turn to professionally managed risk management and software providers for various types of stress tests.

The bottom line – defining an investment stress test

Investment portfolio stress testing isn’t about predicting the future, it’s about identifying and adjusting for risks. Just as Covid-19 did more than just expose weaknesses across any number of areas, stress testing can also reinforce investment strengths. Good investments can be doubled-down upon. Poor investments can be eliminated. Important investing decisions can be made. Investment priorities can be confirmed.