Geoff Considine

Stress Testing Your Portfolio

Correction:

Ron is correct: Bob's portfolio would have lost 19% of its value even without any withdrawals. Before withdrawals, the stress test formula proposed in this article would suggest a 'worst case' of 8.7% - 3*10.6% = -23%. Had Bob done the stress test ahead of time, he could have tuned down his risk level if this was too severe blow. Bob did not have a very well diversified portfolio (according to QPP) and I am in no way saying that this was a great portfolio choice. My point is that a Monte Carlo model, properly stress tested, would have alerted Bob to the risks in his portfolio.

I emphasize: Milevsky's point (and I agree) is that we can never be sure whether we estimate the probability of extreme events well--but we can stress test to see if the 'worst case' events that we can estimate are survivable.

On a related note: there have been some famous cases in which quant models have predicted that the things that hit their portfolios were 25 standard deviation kinds of events--i.e. effectively impossible. This was true in 08 and also in the case of LTCM. The models were clearly wrong. 3 standard deviation events do happen, and we are also saying that we know that they will probably happen with greater frequency in real life--which is why stress testing to ensure survivability of such events is so important.