You must have heard of “Stress Test” carried on American and European banks during the 2009 crisis which brings out the reality on under-capitalisation of banks and how prepared they are to face unfavourable economic scenario. As per Investopedia, bank stress test is an analysis conducted under unfavourable economic scenario which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments. The basic reason for doing the same on banks were to find out that how much they are exposed to Credit Risk, Market Risk, Liquidity Risk, etc and how better or worse they can perform or manage in such kind of crisis. Since then stress test is used to evaluate the strength of the financial institutions.
Stress test in Personal Finance:
Crisis is not limited to Economy or corporates. Whatever is happening in the economy is directly or indirectly affecting us. Moreover in our personal financial life, we face so many situations affecting our financial situation like job loss, health problems, car break down, accidents, sudden rise in children’s school fee etc. so it becomes inevitable that we should also pass through a stress test to find out how prepared are we to face or manage such kind of crisis. Stress testing is a useful technique for determining how a portfolio will fare during a period of financial crisis. Now portfolio can be of any type like Investments portfolio, Income portfolio, expenses portfolio, insurance portfolio etc.
How to do a Stress test on Personal Finance:
1. Write down your financial situation in detail
a) Your income from all the sources,
b) Expense details like your monthly rent, children’s school fees, House expenses, vacations etc.,
c) Your asset details like your financial assets, Real assets etc.,
d) Your liabilities details like your EMIs on home loan, personal loan, car loan etc.
2. Brainstorm and write down some simulation scenario question.
a) What percentage different sources of income carry in total income portfolio and what effect it will make in your personal finance if one or two sources get stopped? For e.g. what if Rs 10,000/- p.m. that you get from your tenant suddenly stops…would you be able to continue with your EMI payments?
b) What percentage different areas of expenditure carry in total expense portfolio and what effect it will make in your personal finance if there’s a sudden rise in one or two areas for e.g. what would be your personal finance situation if suddenly your kid’s school fees rise by 50% and which carries around 10% weightage in your total expense.
c) What’s the liquidity situation in your assets portfolio? This means what percentage of portfolio is immediately liquidable in case of emergency requirements for e.g. if you suddenly met with an accident, then do you have enough liquidity to manage the family expenditure or you suddenly get a call that your cousin/nephew has got engaged and marriage is planned next month…are your finances ready to manage such sort of sudden expenditures.
d) What percentage different assets carry in your investment portfolio and how volatile your Investment portfolio is? What affect your Investment portfolio will have if there’s sudden fall in the stock market or due to a government policy effecting real estate market.
You have to do some brainstorming yourself or with your family members and other stake holders to find out different simulations. You may also take the help of financial planners.
3. Find out the best possible answers to simulation questions
Like for the question asked above, if you have enough liquidity, sources of income, proper asset allocation in investments, adequate insurances to fall back upon with which you may not feel pinch in any of the crisis situation then it’s completely fine .You passed the test. But if in any of the situation you don’t have the comfortable answer then that is the cause for concern.
What if you can’t pass your own stress test? Unlike a bank, you probably can’t go out and raise more capital, unless your relatives are very generous. There are some ratio analysis techniques which can help you figure out what should be the liquidity position in your assets, the maximum debt you should take and many other things
But ultimately this is you who have to work on the situation and bring your finances in order. You can reduce your spending, pay off your costly loans, Follow a proper asset allocation approach and do goal based investing, diversify your investments or you can set up a line of credit for use in emergencies.
See, there’s no requirement of having every penny that you would need to get through a crisis. But figure out how much you will have, how long it will last and where you could get some help if circumstances beyond your control hit your family’s finances. You should not wait for any unfavourable situation to do such test as what Americans have done. It’s better to learn from other people’s mistakes and do a stress test on your own personal finance to manage the uncertainties confidently.
Great Article Sir, a refreshingly different perspective on financial plannning. Recently, i read an article on similiar lines on Financial Planet suthored by Mr.Martin Iglesias. It talks about how financial planners need to communicate effectively to clients to prepare them for unexpected events…Sharing the Link…
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