by
Elizabeth Moran | Dec 02, 2014
IN RECENT DAYS the regulator of all banks and approved deposit-taking institutions APRA announced that all of the capital assigned to protect the major banks’ $1.25 trillion mortgage books would be wiped out if there was a “severe downturn” in the housing market.
It’s APRA’s job to make sure the banks continue to operate and so it stress tests their capital reserves to understand how they would perform under various scenarios. While the news is worrying, I think we can learn from the stress testing APRA routinely performs on the banks. In fact it makes very good sense to routinely 'stress test' your own investment portfolio.
REGARDLESS OF WHETHER YOU ARE IN ACCUMULATION OR PENSION PHASE THE TEST IS USEFUL:
Practically, I would use a spreadsheet to list all of my investments and then apply various assumptions to each asset class. If you want to test a “severe” downturn go back to the GFC and use those sorts of declines in income and capital value.
If you don't remember just how dramatic the downturn was in the GFC...let's recap: The ASX200 lost 55 per cent of its value by the time we reached 'the bottom' in March 2009.
Hybrids lost around 30 per cent, as did the higher risk bonds, while senior bonds in low risk companies such as the major banks retained their value.
You could assume investment grade corporate bonds lost say, 15 per cent in value, while those with very high credit ratings and Australian government bonds at least kept their value.
While shares and hybrids may have lost income, bond investment income would have been paid unless the company went into wind-up. That certainty is one of the main reasons investors diversify into bonds.
Cash holdings are, at the moment, government guaranteed up to $250,000, so under a stress test any account in any institution up to that value would retain its full value.
I’m not a property expert, but a worst case scenario could be a 30 to 40 per cent decline in value, or more for a commercial property and a complete loss of income if there’s no tenant.
If you have negatively geared into shares or property your losses will be exacerbated and you’ll need to find extra income to cover repayments.
The reason you’d stress test your portfolio is to make sure that it would deliver the income you need and maintain a capital value that can keep generating income. Just like the banks, it’s about making sure you have the capital backing and the cashflow to keep yourself afloat.
When you work out the revised value of your portfolio and your expected income, you can then compare this to your needs. This is called liability matching. Does your portfolio provide you with enough income and minimum capital to sustain your goals in a stressed market?
If the results don’t meet your expectations, you’ll need to consider reweighting your portfolio towards lower risk assets that are more robust in a severe downturn.
I think it’s good to have an exit plan and think about contingencies. What assets do you have that can easily be sold without loss of value? Cash on hand and liquid bonds are good examples.
It's to be expected that most investors will find themselves worrying at times about their portfolios. If you take the time to perform some basic APRA-inspired stress tests you will have a much better picture of whether your asset allocation is robust enough to meet your goals under tough conditions.
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