Stress Test

 

In the world of finance a stress test is an analysis or simulation designed to determine if a company has the ability to deal with an economic crisis. Banks often use this form of scenario analysis to prepare themselves against systemic risk, to basically find out if they can still survive if poop hits the fan 😕 Stress tests can be used by individuals to great benefits as well.

Some people may think I have too much debt and that puts me at great risk, however risk can be measured in many different ways. Sometimes going deeper into debt can actually decrease one’s overall financial risk. But how much risk is too much?

What really matters is can a person withstand a major economic shock to his or her finances. Which is why we need to stress test various scenarios that could happen.

Below I have designed some stress tests for myself. These will help prevent me from over exposing myself to possible insolvency or financial disaster. These are unlikely, but plausible scenarios that could happen in the foreseeable future. Each test has a color coded band of possibilities and outcomes. If I’m currently in the GREEN then there is no need for immediate concern. ORANGE means I am exposed to more risk than necessary and should take steps to relieve some financial tension in that area. RED means I need to address the problem immediately.

The good news is it takes time for an outcome to change across the band of a stress test. For example it’s very unlikely interest rates will spike from 3% to 6% next quarter. It will probably take years, maybe even decades to reach the historical level of market confidence again. So we can use this valuable time to adjust our positions to capitalize on the situation each step of the way. By monitoring stress tests we can catch potential risks before they manifest into real problems 😉

My debt-to-income ratio is about 900%, 😯 which is quite high when compared to the national average of 163%. However my debt to equity (net worth) ratio is well below 200%, which is very manageable. And having a diversified portfolio decreases my exposure to financial risk. Real estate investors in the U.S. and parts of Europe walked away from their underwater homes during the great recession, even though many of them were less indebted than I am today. So ratios are just statistics that mean very little by themselves.

When it comes to personal finance there are no rules to determine what we should do. We must look at the situation in its entirety and not only one aspect of it. We want to increase our probability for financial success, and that could mean taking risks, but at the same time we don’t want to bite off more than we can chew. The point of a stress test is to find that fine line between using calculated risk to bolster returns, and not exceeding our comfort level.

A stress test can remove the need for an emergency fund. If money stresses you out then consider creating a stress test for yourself. It can help you isolate the problems and determine which parts of your finances are most at risk.

  10 Responses to “Stress Test”

  1. This is really cool – gives me ideas on making my own stress test with yours as a reference. Thanks for the idea!

    • Cool beans. 🙂 I’d be interested to see what kind of stress tests you will include in your version.

  2. Liquid these stress tests are exceptional.

    Debt-income-ratios as you know are meant to ‘stress’ the ability to pay back debt based on gross income and monthly debt payments.

    So a DTI of 900% would be impossible to pay back since,

    Ex. (Gross Monthly Income) / (Monthly: Margin + Mortgage + Car Note)

    http://www.investopedia.com/terms/d/dti.asp

    Love this blog! Please clarify, or better yet, make a blog post about it!

    Thank you for your transparency

    • Hi Edwin, thanks for dropping by. 🙂
      You’re correct. Any DTI over 100% would not be very sustainable long term. Unless you live in Canada that is 😐
      This might get a bit confusing so I apologize in advance. But in the U.S. debt-to-income (DTI) ratio refers to your debt payments relative to your income. But in Canada the term used to describe this number is actually called the total-debt-service (TDS) ratio. http://www.investopedia.com/terms/t/totaldebtserviceratio.asp TDS is essentially Canada’s version of DTI. 🙂

      However the term debt-to-income ratio does exist in Canada as well but it means something different. DTI ratio up here usually refers to how much total debt you have relative to your annual income. For example someone who has $25,000 of student loans who earns $50,000 a year would have a DTI ratio of 50%, in Canada. This is even how the Canadian media portrays DTI. http://www.cbc.ca/news/business/canadian-household-debt-hits-new-high-1.1138698

      Personally I like the U.S. definition of debt-to-income ratio more because it measures two items that are both related to cash flow. The Canadian version of debt-to-income doesn’t really make sense to me, because it’s like comparing apples and oranges eh.

      Sorry for the misunderstanding. The meaning of financial terminologies can sometimes get lost between international semantics. I will dedicate a separate post to this topic in the future. 😀 Thank you for the idea.

  3. It is very curious to see how far your 900% investment debt has eclipsed the average Canadians consumer debt of 163%

    Can you say shrewd leveraging? Lol

    And I see what you’re saying. As far as Canadian definitions go, DTI very much seems like a panoramic picture while TDS is a zoomed in focused picture. ‘The nitty gritty’. I agree that Canadian (TDS), and the American (DTI) ratios are very helpful for use investor types.

    Thanks for the DOCS and examples, looking forward to that post! 🙂

  4. Any recommended further readings?
    Gosh, YOU should be lecturing at Sauder.

    • I wrote a related post on stress tests a couple of months ago. I think the most important point is money shouldn’t make us feel anxious or worried. If there’s something about our finances that make us stressed then we should fix it. If growing debt is a concern then stop taking on debt. If income is frustratingly low then find ways to make more money or change careers. If credit score is poor, then learn what to do to improve credit score and then do it, one step at a time. It might take time to get our financial lives to a point that we become comfortable with, but it’s worth it.

      I would be honoured to guest lecture at UBC. Actually my application to become a student at the Sauder School of Business was rejected back in 2005 because my high school grades weren’t high enough. Wouldn’t it be funny and ironic if I went back today to give a lecture? haha. Thanks for your vote of confidence. 🙂

  5. […] ratio, but they refer to it as their “debt to income ratio.” If you’re confused this comment will explain the […]

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