Is Your Portfolio Volatility-Proof? A Financial Stress Test

The stress test, a significant move by SEBI, has stirred the nation from its self-induced sleep. As mutual fund investments continue to surge, reaching a staggering ₹54.5 lakh crore by 40 million investors in February 2024, the accompanying volatility has become a pressing concern.

If you are not aware, SEBI asked the Asset Management companies (AMCsC to do a stress test for all its small and mid-cap funds to check liquidity in case of unexpected situations. So, in orders from the market regulator, fund houses did the test, and the results were nothing short of startling.    

SBI, Tata, HDFC, and many more small-cap funds would need more than 35 days to sell their 50% holding. This raised concerns as it could affect investors’ investments during adverse market conditions.

Given the current scenario, it's crucial for AMCs to stress test every 15 days. Equally important is for you, as an investor, to stress test your own portfolio. That's what we will be discussing in this article.

What is a Stress Test, & Why is it Important for Investors?

Simply put, a stress test refers to the speed (no. of days) at which your invested money can be recovered. This test examines an organisation's ability, like AMC, to liquidate its funds and transact the amount to the investors in case of an unforeseen event.

We are all aware of how unstable and unpredictable the stock market is, right?

So, stress testing your portfolio helps you understand how it might react to the market downturns. It is a smart way to assess the portfolio's resilience in challenging market conditions.

Here’s why it’s necessary:

Stress testing your portfolio is like running fire drills for your investments. Sure, we have heard ever since growing up that we should always think positively, but there are occurrences when doing the opposite becomes a necessity.
So, it might not be pleasant to imagine the worst, but it's crucial for several reasons:

a. Fund Manager’s Ability:

One of the key benefits of stress testing is its ability to gauge how swiftly a fund manager can sell stocks from small and mid-sized companies when faced with a surge of investors looking to redeem their units. This scenario is designed to mimic the panic often accompanying a market downturn.

After the 2008 financial crisis, the onslaught of losses that every investor felt on the planet, especially in the USA, led to the introduction of regulatory stress testing. Doing the same for your portfolio is crucial to avoid similar negative economic events.

b. Price Swings:

When adverse market conditions arise, panic selling leads to a bearish rally. This caused the stock price to fall immediately, leading to a significant loss.

Doing stress tests beforehand informs whether selling these stocks will have a big impact on their price or not.

c. Identifies Weaknesses:

Stress testing exposes potential vulnerabilities in your portfolio that might not be obvious during good times. By simulating downturns, you can see which assets might take a bigger hit, revealing an over-concentration of risk.

d. Informs Adjustments:

You can make informed decisions about adjusting your portfolio based on the stress test results. And I am not only talking about diversifying more. There could be letting go of some of the holdings involved, increasing stable assets, or even changing your overall investment strategy.

e. Reduces Emotional Investing:

When markets plunge, emotions can run high. Stress testing prepares you mentally for potential downturns, making you less likely to panic-sell and potentially lock in losses. Hence, it also works for your peace of mind.

How to Stress Test Your Holdings?

Now that you understand the incredible benefits of stress testing your portfolio let’s explore how you can easily begin. Rest assured, it’s not complicated. All you need to do is compile a list of questions or tasks for yourself:

1. Take Inventory:

Make a list of everything that affects your money. From how much you earn to how much you spend. This includes:

a. Income: Everything that brings money to your bank account- your salary, savings account interest, side hustles.

b. Expenses: Everything you spend money on- rent, groceries, utilities, entertainment, vacations, etc.

c. Assets: Your savings, car, house, any stocks, funds, and other investments you own.

d. Liabilities: Money you owe on loans, credit cards, etc.

2. Identify the Challenges:

Bring out the overthinker in you to the forefront and imagine what might happen in the future. And then ask these questions to yourself:

a. Job Loss: What if you lost your job or one of your income sources? Could you manage from your savings & other income? If so, then for how long?

b. Unexpected Expenses: What if your car broke down or you had a medical emergency? Do you have enough savings to handle it?

c. Market Swings: What if the stock market crashed? How would it affect your investments? Would you need to sell your stocks or other holdings?

d. Rising Costs: What if everyday things like groceries or gas became more expensive? Could you adjust your budget?

What were your answers? If most of them were a big fat “NO”, then this means there is an urgent need for you to reprogram your investments and savings.

3. Plan for the Worst (and Hope for the Best):

Here's where you should start:

a. Enough Savings: Aim to have enough savings to cover several months of expenses in case of emergencies. Your emergency fund should be at least 6 months of your salary. 

b. Diversified Investments: Spread your money across different investments to reduce risk. Refer to this link to know the standard asset allocation for your portfolio.

c. Multiple Income Streams: Having more than one source of income makes you less vulnerable to job loss.

d. Proper Insurance: Health insurance, car insurance, etc., can protect you from unexpected costs. Bad things often come in pairs, so bulletproof your savings with a good insurance policy.

4. Testing Different Assets:

Different assets, like equities, mutual funds, etc., require slightly different approaches when preparing for the worst. Here's a glimpse of how to do it right:

a. For Stocks:

 Research individual stocks in your portfolio. Look at historical performance during past downturns or similar events.

Consider the stock sector and its vulnerability in that scenario, such as cyclical sectors. People cut back on spending on non-essential items during recessions, hurting companies that sell cars, appliances, and other discretionary goods.

Be prepared for another market downturn scenario that interest rate hikes could trigger. Rising interest rates can make borrowing more expensive, potentially hurting sectors that rely heavily on debt, such as real estate, utilities, etc.

Online resources might offer stress-testing tools for individual stocks. Remember to use them cautiously; historical performance doesn't guarantee future results.

b. For Mutual Funds:

Analyse the fund's prospectus and annual reports. Look at the fund's asset allocation, i.e., percentages in different asset classes like stocks and bonds. This helps estimate how the fund might react based on the scenario's impact on those asset classes.

Past performance of the fund during similar events can also be an indicator. Refer to the recent stress test results by the respective AMC to gather insight into the fund's ability to recover your capital.

The Bottom Line

One last cautionary advice: The above factors are suggestions, not guarantees.

Depending on their specific strengths and weaknesses, some companies within a sector might outperform the broader market during a downturn. Hence, it's always important to research individual companies before investing.