What is a stress test?
A stress test determines if you have the ability to deal with a financial crisis if things go pear-shaped. It makes the impact of unlikely, but plausible events measurable and transparent. This lets you predict potential problems your finances may face in the future so you can address them early and sleep at night worry free. 🙂
A stress test is an alternative solution to an emergency fund. But there are some differences. Emergency funds are great, but they lack tangibility. The popular rule of thumb is for people to have enough cash in their emergency funds to “cover six months’ worth of essential expenses,” writes personal finance guru Gail Vaz-Oxlade on her blog. I’ve heard other professionals say this as well. It’s solid advice. These knowledgeable gurus are not wrong. But six months is quite an arbitrary time period. Why not four months or nine months? An emergency fund is a good start to financial security. But perhaps it’s not quite enough to give you complete peace of mind. This is where stress testing can come in handy.
The advantages of stress testing your finances
A stress test will categorize all your risks, quantify them, and tell you exactly how much money you should keep on hand, and more importantly, why. It removes all traces of uncertainty and doubt. It can bring you a strong sense of financial stability. 😀 It’s also flexible and accommodating based on your changing financial needs. For example if you renovate your kitchen a stress test can help you calculate a budget. And it can provide solutions in case of complications or unexpected costs. A stress test will also show you warnings in the changing economy, like potentially rising mortgage rates, so you can prepare for it ahead of time.
Having $15,000 or 6 months worth of expenses in an emergency fund doesn’t tell you why that amount is important, or exactly how that money would be used in a real life situation. You can’t do anything with an emergency fund except wait for an emergency to happen. But a stress test allows you to be proactive instead of reactive. 😀 Maybe the most expensive out of pocket cost is $2,000 to fix your car if it gets damaged. Then a stress test will help you maintain at least $2,000 or available credit at all times. This way you don’t have to constantly worry about it. 😉
My stress test scenarios
Below are six stress tests that I have made for myself. You can use them as reference/template to create your own. Because stress tests are so granular and custom in nature, each person’s will be different.
Each stress test example below has two parts: A brief description of my current situation and how I plan to deal with potential risk in the future, and a color coded band of possible outcomes. Green values represent no risk of financial difficulty any time soon. Yellow and orange mean I should probably take precautions and reduce risk in that specific category. And red means something is very wrong and I need to take immediate action.
If money stresses you out then consider creating a stress test for yourself with these similar parameters. 🙂 It can help you isolate the problems and determine which parts of your finances are most at risk.
I have created a dedicated stress test page for regular, future updates.
If you are worried about your debts, investments, emergency fund, budgets, or anything else financial related then consider making a stress test spreadsheet to track your financial health. If outcomes are in the green then relax and enjoy a beer. 🙂 But if a scenario starts to move towards a more risky outcome then that’s a signal to pay attention.
Stress tests can give you a better understanding of your exposure to a wide range of financial risks. This builds confidence in your ability to manage your own money. Even with a fully funded, maxed-out emergency fund, you may still question whether or not your rainy day fund is really big enough. But if you fully stress test your finances against all probable events, you can be sure you’re well prepared for anything. 🙂
Many people deal with financial stress regularly. But it doesn’t have to be that way. By monitoring stress tests you can catch potential risks before they manifest into real problems. Where on the band should the outcomes be green and safe, and where it should start to feel risky will depend on your age, financial goals, and appetite for risk. Managing your own money doesn’t have to be hard or complicated if you have proper tools and goals. 😀
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Random Useless Fact:
Interesting… I’m not sure I’d be willing to go this far and formalize where I stand in this manner. For me I keep this more in my head. That said I have track my finances daily, every penny in and out, which over the years I have managed to have historical data to compare too, which in turn tell me the direction I’m headed, and then also provide me data for extrapolation, real time. We are also at a different phase of our lives, and as such I use very little leverage to achieve my goals, which is probably where the need for a Formalized Stress Test System makes perfect sense… Thanks for sharing what you do and why you do it show how you’ve gotten to where you are! – Cheers.
The less leverage you have the less likely you’ll need to be so formalized with your finances. When some people asked about my debt and risk it occurred to me that I haven’t really addressed it from a scientific point of view. I use to keep all this information in my head as well, but I realized that it wasn’t fair for me to keep all this to myself. By making these scenarios transparent I feel like I can better explain my situation and show that I am in a very stable financial position right now 🙂 If circumstances change I will change my actions accordingly.
I remember seeing your stress tests when I snooped around a long time ago and thought it was really cool – awesome you’re making it a dedicated page!
I remember your comment 🙂 I figured it was time to bring the topic up to the front page.
Hehe, I counted 11 yellow smiley faces on this post. 😀 You, my friend, are very analytical to anything financial. I can see the depth you go into when researching your next financial score. It’s nice to see how you evaluate your situation in the five factors.
I agree with you about the emergency fund. I guess the point to an EF is to not touch your investments and to let them grow. But EF is usually sitting in a savings account earning minimal return. My emergency fund is my stocks in my non-registered account and TFSA. They are all producing passive income, well, most of them. If I need to sell them to fund an emergency, I’ll probably sell my loser stocks that I don’t like. Take a net loss is fine from time to time.
My EF is my stock portfolio too. I don’t like the idea of money not doing any work for me. Stress testing shows that one doesn’t require a traditional emergency fund to be financial protected.
Wow, this is really a big help! Honestly, money stresses me out and I’m glad that I read your stress test.
Taking control of your money can be very empowering.
Very interesting. I think I’m on the green sides for all of those categories too. 🙂
Great to hear dude. As long as we revisit our situation from time to time we will do just fine :0)
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