The Concept Of Stress Testing

Stress-testing is a term which has made it into the news a lot over the last three years. The phrase was once used mostly used in engineering or perhaps medicine. However, in recent times you could be forgiven for thinking that this was a financial term. Stress tests now seem to have been devised to be applied mostly to banks. Since the financial crisis of 2008, U.S. and European banks have undergone several rounds of tests and have been declared to be of varying health.

Interestingly, this idea of a stress-test has its uses in personal finance as well. You could stress test various aspects of your financial situation and see how things would work out in crisis. First, let's see how the bank stress-tests were done. That will give us some idea of what we need to do on a personal scale. In the original bank stress-test that U.S. Federal Reserve did back in 2009, they hypothesised two economic scenarios, one which they called the baseline scenario and the other an adverse scenario. For banks, the two stress-test situations consisted of economic growth, interest rates, and since this was the US, real estate prices. I don't really remember what the results were, and the tests were widely derided as a publicity stunt that had real purpose except to soothe the feelings of panic. Of course, the official view was that the stress-tests were intended to pick out weaknesses in the banks' financial health. But that does not mean that the concept is unsound and it can't be used legitimately. In fact, both the goals of the bank tests-psychological comfort and identification of problems are just as valid when applied to an individual's investment portfolio.

It's hard to work out an exact recipe for a stress test since everyone's situation is so different. But let's figure out a few principles. The idea is to take the external factors that can affect your finances and see what happens as a result. Here are a few possibilities. Rising interest rates could raise your loan repayments. The stock markets could refuse to head up for an extended period of time. Inflation could increase your household expenses as well as eliminate the real returns you get from your fixed income investments. On the inputs side, your income could go down, for whatever reason.

But these are just generalities. A stress-test means being quantitative. To do that, you should put numbers to all this. What happens if your house EMI goes up by another Rs 15,000 a month? Or the value of your equity fund holdings declines by Rs 5 lakh? To conduct a real stress-test, it would be useful to take such concrete examples and write down what your financial outlook would be like if it happens. Normally, most of us are optimistic about the future and carry on hoping that the best will happen. The pay-off for this exercise comes when you start thinking of what you would do to actually solve the problem. What would you actually do if that housing loan EMI gets too big (a real problem for many people). You would probably try much harder to think of ways you could retire part of the loan, perhaps by liquidating some other asset or some investment. The interesting part is that if you do this stress-test when you don't need to, you could actually think of options that you may not have thought of while letting things drift on normally. Perhaps it would make sense to try and hard to cut down loan even when you don't have a severe need to.

Finally, a personal stress-test can actually be a stress-test in the medical sense. When you sit down and imagine all these dire things happening, your heart will probably start racing. How hard it races would be a good indicator to which situations you should work towards preempting.