Stress Testing as a Risk Management Tool for Financial Professionals

March 27, 2018

Heads or Tails

In 1979, two behavioral economists, Amos Tversky and Daniel Kahneman, ran a famous experiment to understand how averse to loss humans truly are. The experiment involved the ultimate game of chance, flipping a coin. The two economists simply asked their subject if they would accept certain terms of a bet based on the outcome of a flipped coin. Example being, heads you win $100, tails you lose $100. After many different iterations of this bet and varying the amount of risk and reward, the conclusion was that on average people needed to receive two times as much in reward as they were willing to lose to take the bet (ex: heads you win $200, tails you lose $100).

Risk Aversion

This simple experiment clearly shows the human tendency for loss aversion. Embedded within all of us is a natural tendency that creates more pain from loss (more than two times more) than we receive pleasure from gain. This psychology becomes even more evident for financial professionals (private equity, investment bankers, and asset managers) given their daily job function focuses on risk management and their asset base and human capital is highly correlated with markets.

Throughout our research, insulating financial risk and avoiding loss is on the top of many financial professionals’ minds. As with any industry, some individuals are more risk averse than others, but financial professionals tend to reduce risk in their portfolios to counter balance the increased risk they inherently take on being tied to the markets and overall economy.

Stress Testing

An important strategy that we developed to help financial professionals through their fear of loss is a deep and robust planning process. We utilize this plan as a risk management tool:

  1. A thorough understanding of the balance sheet and future goals is a critical first step. This allows us to create a base case scenario and understand what the appropriate level of risk should be to successfully manage all the future goals.
  2. After understanding the base case, the next step is to stress test the plan for poor market returns, lower than expected payouts, higher inflation, and a multitude of other potential scenarios. A stress test is important in understanding the true risk to the success of one’s plan.
  3. Getting comfortable with potential outcomes can allow for decisions to be made in a moment of clear consciousness.

Loss aversion is a human behavior that has been proven to change behavior in both moments of distress and tranquility. Creating a foundation and building a strategic plan can allow for risk management systems to be put into place. Stress testing the plan can allow for clarity in moments of turmoil. Forming this clarity can allow financial professionals to feel confident about their current status and build a successful plan and future.