Compare
| Stress Test Type | Method | Example |
|---|---|---|
| Historical scenario | Apply actual past crisis returns | 2008 financial crisis, COVID March 2020 |
| Hypothetical scenario | Design a plausible shock | China invades Taiwan, Fed hikes 300bps |
| Sensitivity analysis | Vary one factor at a time | What if rates rise 200bps? What if oil doubles? |
| Reverse stress test | What scenario would cause max tolerable loss? | What would have to happen to lose 30%? |
Key point
Reverse stress testing is the most valuable exercise. Instead of asking ‘what if X happens?’, ask ‘what would have to happen for me to lose 30%?’ If the answer is a plausible scenario, your portfolio needs restructuring.
Try it
Apply the March 2020 COVID scenario to your current portfolio. Most equity portfolios dropped 30–40% in 3 weeks. Can you tolerate that drawdown? If not, adjust now.
Check-in
Your reverse stress test shows a 30% loss requires both a recession AND a sector-specific shock hitting simultaneously. How concerned should you be?
Key insight
Check-in
You stress-test a portfolio against a '2008-style' scenario. The model says max drawdown would be 35%. Real 2008 saw -42% for your asset mix. Why might the stress test UNDERESTIMATE actual crises?
Check your understanding
Sit with the ideas.
During normal markets, your equity holdings and corporate bond holdings have a correlation of 0.3. You run a stress test using the 2008 financial crisis. What is the most important adjustment to make?
Why: