Last updated 05/11/2022
Stress testing of finances is not a new practice. In fact, after the 2007/2008 global financial crisis, stress testing became standard practice for financial institutions. The practice tests the firm’s vulnerability in case of a market crisis or another recession. If institutions can do this, so should you. The question is, would you pass a personal finance stress test?
On an individual level, the stress testing shows you how you’d fare financially during a bad period in your life. You can always take the test at any time, but it is important to do it at least once or twice a year. Or in case of a job loss or a sudden considerable expense.
How to Stress Test Your Personal Finances
1. Conduct an In-depth Analysis of Your Financial Position
How stable are you financially? You don’t need to have millions in your account, but would you afford to meet your expenses during a crisis? An in-depth analysis of your finances involves examining your monthly expenses, income sources, assets, and other liabilities like insurance payments and loans.
Having a budget will make it easy to stimulate your monthly expenses. If you don’t have one, it’s time to take all your credit cards, bank, or MPesa statements, make a spreadsheet, and try tracking any payments for the last 6 months or so. This should give you a fair outlook of your monthly expenses for utilities like rent, grocery, transport, debt payments, and other minor expenses.
2. Come up with simulation questions
Now that you know your financial position, the next step lies in deducing simulation questions that impact the financial items. Such questions include:
- What contribution do the sources of income have to your overall income portfolio?
- What percentage does each expense have to the total expenditure?
- What’s the effect on your income portfolio if you lose one or more income sources?
- If expenses increase, what’s the overall impact on your finances?
- How liquid are your finances in case of an emergency?
- Do you have the right insurance policies?
- Are you up to date with debt payments?
- What’s your asset allocation, and is it in line with your investment goals and strategy?
3. Obtaining answers to the simulation questions
The above questions will give a thorough check of your finances, from your income and expenses to investments, debts, and risk management. Once you have the answers, it will be easier to simulate the best solutions. What should you be looking for when answering these questions? You should look at;
- Adequate liquidity levels on your finances to meet urgent cash needs
- Recurring sources of income to manage expenses
- Robust debt management to avoid attracting late payments fees, penalties, and getting into a debt cycle
- Obtaining a goal-based investment
- Proper asset allocation for your portfolios
- And insurance covers in case of severe emergencies or issues such as accidents or robberies.
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4. Examining the Worst-Case Scenario
Determining the worst-case scenario after obtaining solutions for your simulation questions will provide a framework on which you can base your decisions. Therefore, look at this case with the worst possible situations. This will constitute an inflated monthly expenditure and a reduction or total loss in the sources of income.
Your income sources may become deflated as the turmoil persists, and your savings should help you face the tides. You should know how long your savings can last by doing a bit of math with the above assumptions. Also, consider getting a side hustle, especially if you have only one source of income.
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Merits of Personal Finance Stress Test
Conducting a stress test on your finances provides confidence to face turbulent storms and has ample benefits. For one, you can organize your finances well and anticipate contingent situations. It also allows you to obtain insurance coverage, plan for emergency funds, have a budget, and diversify your assets to minimize risks.
Getting Back to the Drawing Board
The results of the stress test clearly show the financial health of your finances. If you are not comfortable dealing with a financial crisis with the projections’ status, this is where you get back to the drawing board.
You can gain control over financial setbacks by:
- Budgeting and keeping track of your expenses consistently
- Obtaining an emergency fund account that is interest-bearing. Save at least 6 months of your living expenses in this account.
- Reducing expenditures, like discretionary expenses such as entertainment and anything that is not a necessity.
- Automating savings and investments to avoid overspending.
- Diversifying your investments with assets that have negative correlations. These are assets whose prices move in different directions, like bonds and shares (stocks).
- Managing your debts, like repaying high-interest debt faster with extra money after budgeting or negotiating for better repayment terms with your lender to avoid suffocating your finances.
Related read: Building an emergency fund and why it’s important
Getting a hold of your finances and performing a stress test should be regular exercise. The goal is to determine whether you will pass a stress test during sudden trying situations. You can do this annually, semi-annually, quarterly, or anytime there is a significant change in your life. If you do not feel confident about your current financial position after the stress test, take proactive actions toward managing your finances for the better. This could range from replenishing your emergency fund, adding another source of income, reducing a particular expense category, and budgeting consistently.