Tags: Hedge Funds, Investing Strategy

How to Slash Risk and Avoid Losses With a "Stress Test" of Your Personal Investment Portfolio

By , Money Morning •

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.

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