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 in case of a job loss or a sudden considerable expense. With the ongoing Covid-19 pandemic, it might seem like it’s a bit late for a stress-testing exercise. But it’s never too late to see where you stand, especially now that there’s no end in sight for the pandemic.
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.
If you have a budget in place, it will make it easy for you to stimulate your monthly expenses. If not, it’s time to take all your credit cards, bank, or MPesa statements, make a spreadsheet or use a budgeting app, 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, 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 of the income sources?
- If any of these expenses increase, what’s the overall impact on your finances?
- How liquid are your finances in case of an emergency?
- Will your personal finances be affected by stock market fluctuations?
3. Obtaining answers for the simulation questions
The above questions will give a thorough check of your finances. Once you have the answers, it will be easier for you to simulate the best solutions for any emergencies.
What should you be looking for when answering these questions? You should be able to look at:
- Adequate liquidity levels on your finances to meet urgent cash needs
- Recurring sources of income to manage expenses
- Obtaining a goal-based investment
- Proper asset allocation for your portfolios
- And insurance covers in case of severe emergencies or cases such as accidents or robbery.
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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 from which you can base your decisions. Look at this case with the worst possible situations. This will constitute 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 personal finance stress test not only provides confidence to face turbulent storms but also has ample benefits. For one, you can organize your finances well and anticipate contingent situations. It also allows you to obtain insurance cover, plan for emergency funds, have a budget, and diversify your assets in a bid to weather the storm.
Getting Back to the Drawing Board
The results of the stress test clearly show the financial health of your personal 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:
- Obtaining an emergency fund account that is interest bearing.
- Reducing expenditures, such as personal loans.
- Automating savings to avoid overspending.
- Diversifying investments to assets with negative correlations.
- Budgeting and financial management consistently.
Getting hold of your finances and performing a stress test on your personal finances should be a regular exercise. You should obtain clarity on whether you will pass a stress test with sudden trying situations. There has never been a better time to perform this personal finance stress test for your personal finances’ soundness. If you do not feel confident after conducting the stress test, be sure to take proactive actions towards managing your finances to avoid falling into a financial pitfall.