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.