Portfolio stress testing is a simulation of how a portfolio would perform under various market scenarios, especially extreme ones. The aim is to determine how the portfolio would handle adverse conditions, and whether the investor's goals and risk tolerance would be met. The results of stress testing are used to make informed investment decisions, assess the portfolio's resilience, and adjust the investment strategy if necessary.
A few examples of scenarios that can be tested include:
Market crashes: This scenario simulates a sudden and significant decrease in the value of stocks, bonds, or other investments in the portfolio. This helps to determine how much the portfolio value would decline and whether it would recover in the future.
Interest rate hikes: This scenario simulates a sudden increase in interest rates, which can have a negative impact on fixed-income investments such as bonds. It helps to assess the portfolio's sensitivity to interest rate changes.
Inflation: This scenario simulates a rise in consumer prices, which can erode the value of money over time. It helps to determine the portfolio's ability to generate returns that keep pace with inflation.
Currency fluctuations: This scenario simulates changes in the exchange rate of a currency, which can impact investments denominated in that currency. It helps to assess the portfolio's exposure to currency risk.
Portfolio stress testing provides valuable information that can be used to make informed investment decisions and manage risk effectively.
