As a financial adviser, your investment philosophy is a set of beliefs and principles that guide your decision-making process when it comes to investing in different financial assets. It is important to periodically stress test your investment philosophy to ensure it is well-rounded, adaptable, capable of withstanding market fluctuations and other unexpected events, and is meeting your clients’ objectives.
The last few years – through the pandemic and other phenomena – have proven an investment philosophy cannot stagnate, as it can quickly become obsolete. A robust investment philosophy that can withstand the test of time and can account for risks is something advisors are able to lean on during volatile times and when conversing with clients.
In this article, we will explore a few simple steps and a quick case study to illustrate the importance of stress testing your investment philosophy.
5-step process to stress test your investment philosophy
Step 1: Research & Define
The first step is to ensure that you have an apt investment philosophy by conducting broad research. This could include reading case studies showing how a successful investor/portfolio manager has built their investment philosophy, or engaging with industry peers to find out what their investment philosophy consists of. Through this process, you can then evaluate what resonates with you and how you form your professional perspective in relation to building an investment philosophy.
As an example, research could include discussions with experts in the industry – fund managers, advisor peer groups (e.g. Ensombl), investment and research committee members within a licensee and academics, just to name a few.
Once you have gathered a wide selection of information, it is now time to combine the best ideas and form your own investment philosophy based on your own conviction.
For example, a well-defined investment philosophy would incorporate high level concepts such as – long-term investing, asset allocation, diversification and maximising time in the market. Using these concepts to form the basis for your investment philosophy could ensure that your client’s portfolio includes sufficient cash to fund two years’ worth of drawdowns, a core-satellite approach (with a blend of active and passive fund managers), diversification across asset classes and within them, and assurance that time in the market is always considered over trying to time the market.
Step 2: Evaluate past performance
It is important to back test your investment philosophy and where possible test it against what you are trying to achieve. This could include reviewing the returns generated by your portfolio and comparing it to a benchmark. It is important to look at past performance (while bearing in mind that past performance is not an indication of future performance) despite the legality of disclosure (i.e. explaining to clients that past performance is not an indication of future performance). A track record is a good base to start from when assessing your investment philosophy’s performance, especially when you do not have information about the future. This analysis can also provide an opportunity to understand how your investment philosophy has weathered different market conditions.
As a practical solution, there are portfolio construction tools from advisors, fund managers and research houses that can assist in this space. This process is called back testing – by constructing a portfolio (e.g. core-satellite) and looking at how past events would affect it.
Step 3: Identify potential stress scenarios
The third step is to identify potential stress scenarios that may negatively impact your portfolio. This could include recessions, crashes, drawdowns, sell-offs, geopolitical risks, or any other events that could cause significant market volatility. The goal of this step is to understand the potential impact that these stress scenarios could have on your investments. Additionally, a SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis could aid this process.
Some examples of potential stress scenarios could include, but are not limited to:
- Human sentiments causing panic in the short run, with market volatility impacting returns;
- Unexpected drawdowns resulting in a fire sale of assets;
- Over diversification potentially suppressing portfolio returns; or
- Negative media (e.g. bank run in March 2023).
Incorporating strategies in your investment philosophy that aim to mitigate such risks over the long-term is crucial. For example, a bucket strategy (through asset allocation) may create the potential to both mitigate short-term volatility of a portfolio and reduce portfolio stress if funds are withdrawn to cover a client’s living expenses. Diversification of assets and a core-satellite approach give the opportunity to reduce the overall downside risk of a portfolio, as most risks experienced throughout history are diversifiable.
Step 4: Conduct a stress test on each scenario
Once you have identified potential stress scenarios, it is now time to conduct a stress test on each of them. This involves simulating the impact of the stress scenarios on your portfolio and evaluating the result. The stress test aims to help you understand the extent to which your investment philosophy can withstand market volatility and other negative events. One metric to quantify the extent of risk is a statistical measure called Value-at-Risk (VaR).
Advisors are often limited in the resources that are available to them within their practices. However, there are tools and software available for portfolio construction and scenario testing such as a Portfolio X-ray tool provided by research houses. Once the portfolio is put through the X-ray tool, fund managers (or platforms with investment offerings) can assist with stress testing each scenario and the impact it may have on your portfolio. If these impacts are not identified as being mitigated (by risk mitigation tools within a portfolio or other means such as diversification or asset allocation), it could mean that the portfolio may not be optimal and may not withstand the downward pressure of the tested adverse event. These tools and software can effectively illustrate the impact of each given scenario, and more importantly, allow you to calculate the value of the portfolio that could be lost on an investment if the ‘stress’ scenario eventuates. This is the statistical measure known as VaR, as mentioned above. If this amount is far greater than what you have expected or communicated with clients, it is then important to de-risk (e.g. increasing negatively correlated assets to equities/fixed interest) or alter your portfolio and investment philosophy. If the calculated VaR is something you are comfortable with, it may be worthwhile to consider adding 10-20% on top of it, as the effect of a downward pressure has the potential to be greater than expected.
Step 5: Review and revise your investment philosophy
Finally, after conducting the stress test, it is time to review your investment philosophy. Your review could benefit from a fresh set of eyes and perspective on your work, as it could uncover potential blind spots. This can be done with the support and guidance from peers in the industry, or professional investment and portfolio managers, but should predominantly take into account your stress test results. Following your review, you should revise your investment philosophy as necessary. It is important to regularly revisit this process to ensure that your investment philosophy remains robust, relevant and effective in meeting your clients’ objectives.
Stress testing your investment philosophy is a necessity in an ever-changing landscape. Our traditional thoughts on how investments work (or how they should work) can quickly become obsolete. Hence, it is also important to constantly keep up to date with recent developments and continuously engage with other professionals in the industry, as it allows us to remain relevant. Periodically revising your investment philosophy is crucial as a fool-proof and timeless investment philosophy does not exist. Adopting a mindset of constantly evolving and adapting to ever-changing conditions, and being open to new ideas as traditional paradigm shifts occur can improve your investment philosophy and advice practice.
If you would like to know more on this topic, the Schroders investment education space on Ensombl is a great place to start, as set out in Step 1 above.
This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders).
This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice.
Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document.
Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold.
Telephone calls and other electronic communications with Schroders representatives may be recorded.
