Stress Test is a scenario analysis that estimates how a portfolio or financial institution would perform under extreme but plausible adverse conditions - market crashes, interest-rate spikes, credit downgrades, or liquidity freezes.
Approach: Two flavours: (1) historical scenarios (replay 2008 GFC, March 2020 Covid crash, 2013 taper tantrum), (2) hypothetical scenarios (Nifty -30% with INR -10% and 10Y yield +200bps simultaneously). Output is portfolio MTM under each scenario.
Example: A balanced fund's stress test might show: '2008-replay scenario: -28% NAV impact over 6 months; 2020-replay: -22% over 1 month with full recovery in 6 months.' Helps the investor pre-commit to staying invested.
When to use: Setting asset allocation in retirement portfolios, deciding whether to leverage a margin trading position, sizing equity exposure for goals within 3 years, and meeting regulatory capital requirements (RBI's annual stress test for banks, SEBI's liquidity stress test for debt MFs).
SEBI caveat: SEBI mandated liquidity stress tests for all debt mutual funds post-Franklin Templeton 2020 episode. Always check the scheme's stress-test disclosure on AMC websites before investing in credit-risk or low-duration funds with concentrated holdings.
Related: Value at Risk, Maximum Drawdown, Downside Deviation, SIP.