Best of the Week
Most Popular
1.RED ALERT: Paris Terror Attacks - What to Expect Next - STRATFOR
2.Paris Terror Attacks, Death Pangs of a Dying Religion, and Impact on BrExit EU Referendum - Nadeem_Walayat
3.Paris Terror Attacks, Islamic State Attempting to Spark Civil War in France - Nadeem_Walayat
4.Three Shocking Charts That Prove Gold Price Rally Is Coming - Sean Brodrick
5.Stock Market Nifty-Fifty Becomes Fab-Five; Return of the 'Four Horseman' - Mike_Shedlock
6.Africa Population Explosion - Why Europe's Migrant Crisis is Going to Get A Lot Worse - Video - Nadeem_Walayat
7.Gold Mining Stocks May Be The Buy Of The Century - Jeff_Berwick
8.Grandmaster Putin Beats Uncle Sam at His Own Game - Mike_Whitney
9.BRICS? No, CRISIS - Raymond_Matison
10.UK Housing Market Affordability, House Prices Momentum and Trend Forecast - Nadeem_Walayat
Last 5 days
Stock Market Top Valuations, at a Critical Juncture - 27th Nov 15
The Top Shopping Opportunity on Black Friday - 27th Nov 15
Economics Is About Scarcity, Property, and Relationships - 27th Nov 15
UK Immigration Crisis Hits New Extreme of 336k Net Migration, up 32% on 2014 - 27th Nov 15
Vauxhall Zafira B Fire Danger Recall - What to Do Video - 26th Nov 15
Triggers In US Dollar Collapse - 26th Nov 15
Apple Stock is a 10-Year Short - Bear Market Environment - 26th Nov 15
U.S. Federal Reserve Rate Hike - 26th Nov 15
George Osborne's War on Buy to Let Sector Trending Towards Doomsday - 26th Nov 15
Will Turkey Drag NATO into War With Russia in Syria? - 25th Nov 15
George Osborne’s Autumn Statement and Spending Review Full Text - 25th Nov 15
Will Fresh QE From ECB Boost Gold? - 25th Nov 15
Sheffield, Yorkshire and Humberside House Prices Forecast 2016-2018 - 25th Nov 15
Investors Watch Out For The Auto Industry… - 24th Nov 15
BEA Revises 3rd Quarter 2015 US GDP Economic Growth Upward to 2.07% - 24th Nov 15
Stock Market Supports Are Being Broken - 24th Nov 15
Is Gold Price on the Verge of a Breakout? - 24th Nov 15
Fed’s Tarullo: U.S. Interest Rates Liftoff Should Wait for Signs of Inflation - 24th Nov 15
Silver Price, COT, US Dollar Updates and More - 24th Nov 15
UK Regional House Prices Analysis - Video - 23rd Nov 15
Crude Oil Swinging For The Fences - A 20 to 1 Option Play - 23rd Nov 15
US Dollar, CRB, Oil, Gas, Copper and Gold - The Chartology of Deflation - 23rd Nov 15
UK Regional House Prices, Cheapest and Most Expensive Property Markets - 23rd Nov 15
Stock Market Rally Losing Momentum? - 23rd Nov 15
Will Gold Price Drop Below $1000 Soon? - 23rd Nov 15
Gold and Silver Sector Big Green Light and Low Risk Entry Setup... - 23rd Nov 15
Limits to Economic Growth - Challenge and Choices - 22nd Nov 15
Long Dollar Trade and Current Copper Price Below Cost of Production - 22nd Nov 15
UK Housing Market House Prices Affordability Crisis - Video - 21st Nov 15
The Fed Has Set the Stage for a Stock Market Crash - 21st Nov 15
Stock Market Primary V Wave Continues - 21st Nov 15
Gold And Silver - Value Of Knowing The Trend - 21st Nov 15
UK Footsie Bulls Set To Foot The Bill - 21st Nov 15
UK Housing Market Affordability, House Prices Momentum and Trend Forecast - 21st Nov 15
GDX Gold Miners’ Strong Q3 Results - 20th Nov 15
End of Schengen, Stock Market’s Technical Strength Grows - 20th Nov 15
Justice for All and The Curious Case of Zambia - 20th Nov 15
Paris, Sharm el-Sheikh, and the Resurrection of Old Europe - 20th Nov 15
Silver Prices and The Management of Perception - 20th Nov 15
Stock Market Nifty-Fifty Becomes Fab-Five; Return of the 'Four Horseman' - 20th Nov 15
Waiting for Goldot Again - 20th Nov 15
Michael Curran Goes Down-Market Shopping for Gold Stock Winners - 20th Nov 15
Why Isn’t This Incredibly Bearish Bond Market Development Making the News? - 19th Nov 15
SPX Appears to have Stopped its Rally - 19th Nov 15
The Great Fall Of China Started At Least 4 Years Ago - 19th Nov 15
Using Elliott Waves: As Simple As A-B-C - 19th Nov 15
Has Deflation Been Ddefeated? - 19th Nov 15
Dow Jones Stock Market Index is Not Going to Crash - 19th Nov 15

Free Instant Analysis

Free Instant Technical Analysis

Market Oracle FREE Newsletter

Reasons to Get Excited About Japanese Stocks

How to 'Stress Test' Your Investment Portfolio

Portfolio / Learning to Invest Aug 10, 2010 - 06:35 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJack Barnes writes: Back when I was a portfolio manager, I was always looking at ways to "stress test" my portfolio. In other words, I was on the constant lookout for ways to hedge my holdings, guard against risk, and to anticipate anything the market could throw at the stocks, bonds, options and other investments contained in my portfolio.

Hedging involves much more than just anticipating the movements on individual stocks. The financial markets are so deeply interconnected that - to the distant observer - they might appear to be seamless.

To show you what I mean, let's look at oil: It's a great real-world example, ripped right from the daily headlines, and there's a strong emotional component to it, too, since the "black-gold" commodity touches the lives of investors and consumers alike. I'll demonstrate how even retail-level investors can apply this "portfolio-stress-test," risk-management technique to their own portfolios.

Let me give you an example of just how convoluted the markets appear to be. If you are exposed to U.S. crude prices - for example, you're holding a U.S.-based oil refiner like Valero Energy Corp. (NYSE: VLO) - you really need to get a quote for Brent crude and the Argus Sour Crude Index (ASCI).

Brent crude, which is traded in London, tells us what the world market is really paying for the same quantity of essentially equivalent oil. Argus is key because that tells us the price that the United States is paying for Saudi Arabian oil.

The U.S. markets have been - and continue to be - distorted by the capacity of storage available in Cushing, Okla. Cushing is where U.S.-traded commodity contracts are settled. Newcomers are often surprised to discover that one very small city of 8,000 people - which seems to be in the middle of nowhere - sets the price of oil for the U.S. futures market in New York City.

The pipelines into and out of Cushing's tank farms can be affected by a single major refinery being down for repairs -which is precisely what happened in 2008. That closure of a single user of West Texas Intermediate (WTI) - the U.S. benchmark - caused Cushing to fill up with oil, artificially depressing oil prices around the world.

After this event, Saudi Arabia announced that it would no longer trust the WTI price, and would use Argus for its base line going forward. Given that a single refinery distorted global oil prices for months, you can see the Saudis' point.

That's why I began using the "stress-test" technique. Sometimes, a single variable will alter a sector's entire outlook. For an institutional investor, that sort of unanticipated development can savage a portfolio. For a retail investor, such a turn of events can obliterate a nest egg.

Anatomy of a Stress Test
The financial use of the term "stress test" came into vogue after the global financial crisis eviscerated the U.S. banking sector. I'm sure you've heard the term. These high-level "what if" scenarios were designed to provide a much greater degree of banking-system transparency following the near collapse of the financial system. The banks needed to show that they could handle a drop in home prices, or they had to raise capital.

The stress-test result: Of the 19 major U.S banks that were tested, 11 had to raise capital.

Since those public tests in spring of 2009, Europe has stress-tested its banks, and now China is doing the same. In fact, in order to get a true assessment of its national banking system, Beijing reportedly ordered its banks to assume a 60% drop in the real-estate market.

In a nutshell, a stress test is a means of scrutinizing your portfolio holdings, and candidly assessing whether that portfolio could ride out a rough stretch - including a "margin call" that's triggered by a steep drop in value of the assets. While simple to say, it is always different in each case.

For example, if I had a large oil exposure in my stock holdings - but felt that near-term oil prices could or would drop - I would hedge, or offset, the risk by buying a "put" on oil prices, while still permitting my equity positions to react to market conditions.

How do I know this strategy would work? Very simple: I deployed it myself under circumstances very similar to the ones I described here.

And it worked great - just as I anticipated.

The non-margin put position essentially served as "insurance." It helped to hedge my long equity exposure to a drop in its primary component: crude-related investments.

Specifically, in a situation such as this one, I would buy a "short-equivalent" position - out of the money - with a minimum of six to nine months of coverage. As my equity positions moved up in price and value, I continued to buy these types of puts at regular, pre-determined points.

While this "beta future insurance" does represent an expense, meaning that I would be eating into the (alpha) returns of my stock-holdings a bit, these puts positions were never significant from an actual dollar-outlay standpoint.

The only risk was the cost of creating the put position. And if there happened to be another Cushing-like incident, my oil exposure would be nicely hedged.

Adding this put position to my portfolio meant several things to me, all of them important. The put position:

•Helped to limit my overall portfolio risk, meaning that I still had direct exposure to the crude futures market, but without the potentially unlimited risk that a true futures position would represent.
•Enabled me to remain invested in the oil market and to pursue the potential that I see there in the long run - and to benefit from the potentially unlimited volatility based gains that are available during a crash.
One final benefit - and possibly the biggest one of all: Knowing what my portfolio was going to do in most of the key conceivable situations helped me to sleep better at night.

So, how do you apply this technique to your own holdings? Let's take a look.

Stress Testing Your Own Portfolio
Let's begin by posing a short list of questions about your portfolio that you need to answer. Generating those answers will take some time and effort, but the energy that you expend here could save you a small fortune in unnecessary losses down the road.

Here are the questions:

◦Is my portfolio diversified in terms of exposure?
◦Is my portfolio hedged to cover losses - or even to make money - if the market moves against my key holdings?
◦If I'm not hedged, and I opt to "stand pat" (make no changes), what is the absolute worst thing that could happen to my portfolio?
◦What can I do to protect my portfolio, or even to make money, if I address the deficiencies discovered by answering question No. 3?
Let's answer each of these questions, to illustrate the thinking that's involved in mentally "stress-testing" your own portfolio. Take a look:

■Is my portfolio diversified? In simple terms, what percentage of your holdings is in cash, stocks, bonds and physical assets? Ratios such as 10%, 50%, 30% and 10% are used to evaluate your total holdings - and your exposure. These can change - and they will - as you seek to maximize growth, or income at different times in your life. When you define your "portfolio," make sure that you include all your holdings. Investors will too often exclude their IRA accounts or 401(k) accounts from this exercise - and don't see the big exposure risk they have as a result.
■Is my portfolio hedged to cover losses - or even to make money - if the market moves against my key holdings? Addressing this question can be as simple as buying puts in your personal account on the Standard & Poor's 500 Index, should you discover that you have a large S&P 500 exposure in your 401(k). If you own a lot of Valero, and believe that a run-up in oil prices would hurt the refiner's results, you could buy "calls" on the United States Oil Fund LP (NYSE: USO) exchange-traded fund (ETF). If you are experiencing near-term weakness in some of your core holdings, you could write some very-near-term "covered calls" against those holdings to fund put purchases. This way your investment is hedging itself in the near term.
■If I'm not hedged, and I opt to "stand pat" (make no changes), what is the absolute worst thing that could happen to my portfolio? Sometimes, investors are afflicted with "deer-in-the-headlights" syndrome. This is when the market goes against you, and you know it, but you freeze - and get run over. And be honest when you answer this question.
■What can I do to protect my portfolio, or even to make money, if I address the deficiencies discovered by answering question No. 3? Can you buy a small position opposite to how your portfolio is leaning, to hedge that risk? Can you employ some of the investments that we detailed in answering question No. 2 to actually generate some income or capital gains for the portfolio?Actions to Take: In the turbulent market conditions of today - with "flash crashes" a newfound reality - take the time to administer a "stress test" to your personal investment portfolio. Your objective is to see how your portfolio will handle a major change in market conditions.

For example, if you are heavily exposed to a specific commodity, what would happen if the price of that basic commodity dropped by 50% in a period of weeks? If you are short a commodity, what would happen if it went up 50% or 100% in a month?

Are you are a bond investor? What would happen if interest rates started to rise significantly, as the world tires of buying U.S. Treasury bonds?

If you are heavily invested in S&P 500 stocks, what would happen if that key U.S. index re-tested the painful lows of March 2009 once again?

My suggestion is to conduct the investment self-review that we've outlined for you in the preceding essay. Once you've done that portfolio assessment, I suggest that you may want to consider pairing some shorter-term ETF options to hedge your long-term exposure to the markets.

Source :

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email:

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2015 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Biggest Debt Bomb in History