How to Reverse Stress Test Your Portfolio
Identify hidden portfolio vulnerabilities before they become losses with this practical framework
Contributor
Hassan Ennadifi
Senior Director, Product Management
SimCorp
What's the worst plausible scenario for my portfolio, and how likely is it?
Traditional stress testing asks: "What happens to my portfolio if X occurs?" But reverse stress testing takes a different approach: "What scenarios could cause my portfolio significant losses and how likely are they?"
Instead of testing predetermined scenarios, reverse stress testing discovers which scenarios pose the greatest risk to your specific portfolio.
This research paper presents a practical, implementable framework for reverse stress testing across linear and nonlinear portfolios
Using real-world examples spanning across multi-asset portfolios, you'll learn:
- How to use Lasso-based regression techniques to identify the critical risk factors that truly matter for your portfolio
- Methods for estimating covariance matrices under both normal and stressed market conditions using Gaussian mixture models
- How to find the worst plausible scenario for any given likelihood threshold
- How to interpret results for both granular (asset-level) and systematic (factor-level) risk analysis
Read this guide for actionable techniques to uncover your portfolio's vulnerabilities before market conditions expose them.