This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner, the adviser for The Motley Fool’s Rule Your Retirement service, and the husband of Elizabeth Brokamp, who has written a darling Halloween-themed children’s book, The Picky Little Witch.

I have a confession: I am an “awfulizer.” I’m always afraid that something awful is around the corner, especially when it comes to my personal finances and the overall economy. Folks like psychologist Martin Seligman (author of Learned Optimism) would point out that my physical and mental health suffers from all my dooming and glooming, and he’s probably right. Nevertheless, as Seligman points out in his book, pessimists are more accurate when it comes to assessing reality. In other words, all you optimists are just deluded!

Plan B for peace of mind
Andrew Grove, who fled communist-run Hungary at the age of 20 and co-founded semiconductor company Intel, had a guiding motto: Only the paranoid survive. (He also published a book of the same name.) No, that doesn’t mean you have to turn into Howard Hughes, who would demand that people remove dust and stains he saw on their clothes, but there’s value in having a defensive nature. People used to tell me that I was just being overly pessimistic. But after the last 11 years, and the accompanying recessions, layoffs, and market crashes, I no longer seem so irrational.

From both a financial and psychological point of view, I’ve learned to live with my “awfulizing” by having a plan for what would happen if my family’s situation changed significantly — what expenses we’d cut, which relatives we’d move in with if we lost the house, even where we’d rendezvous in case a major catastrophe prevents us from getting to our home. (After all, I do live in the Washington, D.C. metropolitan area, and have a picture I took from the balcony of Fool HQ of smoke rising from the Pentagon on Sept. 11.) Fortunately, I haven’t had to put my Plan B into effect, but knowing it’s there has provided plenty of peace of mind.

The past several weeks have inspired me to revamp my Plan B. Some of the reasons are personal (i.e., the possibility of taking in three kids whose parents are unable to care for them) and some are global, namely, the economy stinks and could get worse. Research firm ECRI, known for its well-regarded index of leading indicators, issued a report on Sept. 30 that claims the U.S. economy has already tipped into a recession. Furthermore, the ECRI claims that shorter recovery periods and more frequent recessions will be the norm. They conclude the report with this: “If you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.”

You don’t have to be prone to paranoia to find that a bit scary. If it makes you at all worried, then perhaps it’s time to turn the angst into action by creating your own backup plan.

Income, interrupted
You already have a Plan A — you’re living it. Whether it’s an actual written document is another matter. But your Plan A starts with your current income, which determines how much you can spend, how much you can save, and how long it will take to achieve your financial goals. Plan B is what you do in case there’s a disruption to your current sources of income, be it your job (if you’re still working) or your portfolio (if you’re retired). The actions in your Plan B have three components:

  1. Actions you can take now to prevent an emergency or increase the chances that other resources will be available should you need them.
  2. Actions you will take in case the income interruption occurs — essentially, a thought-out strategy that you can implement immediately.
  3. Considerations of how all these actions could affect your long-term financial goals.

Here are some candidates for the components of your Plan B:

  • Shore up your human capital. No matter what kind of job you have, think in terms of being a self-employed person who must continually impress customers in order to convince them that spending money on you is a good deal. As fund manager John Hussman wrote in an August commentary, “Even people who earn income from a paycheck are entrepreneurs in the sense that they are in the business of selling labor services.” Solidify your good standing with your company and/or your customers. Have in mind a list of other employers, or types of employment, you would pursue in case something happened to your current job. Also, become active in your network. Charles Purdy, senior editor at jobs site Monster.com, told the Wall Street Journal that “The mistake a lot of people make is that the only times their network hears from them is when they have a favor to ask. They don’t think about how they can help the people in their network and build that goodwill.” As the article points out, many jobs are never advertised and are filled through referrals of existing employees. Staying in contact with many people increases your chances of hearing about such positions.
  • Have an “income-outflow cushion.” This is a just a different way of saying “live below your means,” but that’s usually recommended to persuade people to save for some future goal. But keeping spending below your income also has defensive benefits: The more you live below your means, the less you’ll need in an emergency, and the more you can accept solutions that result in less income than what you had before (such as a lower-paying job).
  • Prioritize expenses. Look at the line items of any household budget and you’ll see plenty of categories that can be eliminated immediately if absolutely necessary: entertainment, travel, dining out, gym membership, charitable contributions, and even contributions to investment accounts (if things get that dire). There are others that we’ve grown accustomed to thinking as necessary but really are luxuries, such as cable TV, high-priced cell phone plans, high-speed Internet, new clothes, children’s activities (e.g., sports, lessons) and so on. What are the items in your budget that you would cut immediately if times got really tough?
  • Put your home to work. For many homeowners, the mortgage is their largest expense, and the house is their biggest asset. Considerations for lowering that expense or putting the equity to work are important aspects of any Plan B. Possibilities include downsizing, moving to a location with a lower cost of living, a reverse mortgage (if you’re 62 or older), renting out the basement, and getting your ne’er-do-well adult son to finally pay rent.
  • Sell your stuff. You own more than a portfolio and (if you’re a homeowner) a house: You also own everything in your house. Much of it can be sold in a pinch. As I’ve written before, my family made more than $2,000 by selling things we no longer needed before moving to a new home. We could have parted with even more if we had to.
  • Know from where your cash will come. If you had to access money, where would it come from? Ideally, your first answer would be “my emergency fund, of course.” But if that became depleted, where would you turn? Ideally, it would not be from your 401(k), which is where 61% of respondents of a survey by State Farm Insurance said they’d get extra money. That could lead to taxes and penalties (if you’re not yet 59 ½), as well as compromise your retirement. While everyone’s circumstances are different, here’s a very general list of where you should turn first for cash (There are plenty of reasons for individuals to change the order of these sources of cash, but it provides a general framework.):
    1. Emergency fund
    2. Property or possessions you can sell
    3. Investments in taxable (i.e., non-retirement) accounts
    4. Money you contributed to a Roth IRA (which can be withdrawn with no taxes or penalties; earnings are another matter)
    5. A home-equity loan, if and only if you know your situation is temporary and you have no doubts about your ability to pay off the loan
    6. A 401(k) loan, if and only if you will continue to be employed by the same employer and you have no doubts about your ability to pay off the loan
    7. Credit cards
    8. Retirement accounts
  • Adjust your long-term goals. You future financial needs — such as retirement income years from now — rely on an assumed rate of return, having a set amount of assets by a certain time, and other variables that may not materialize. Consider what you’d do if your portfolio under-performs your expectations. Will you delay retirement? If you’re already retired, are you willing and able to return to work? If these options are unappealing, then act now by spending less and saving more so your future financial goals aren’t reliant on a specific investment return.

Come on, get happy…mostly
Okay, so maybe working from a foundation of fear isn’t the best way to go through life. Seligman (and others) are probably right that perpetual pessimism isn’t healthy. In his book Why Zebras Don’t Get Ulcers, Stanford neurology professor Robert Sapolsky explains that when we lived in the wild and were chased by lions, our bodies reacted to stress pretty well. Today, our stress is lower-level but longer lasting — a constant buzz in our brains that can cause everything from depression to heart disease.

Sapolsky advises us to “find ways to view even the most stressful of situations as holding the promise of improvement, but do not deny the possibility that things will not improve. Balance these two opposing trends carefully. Hope for the best and let that dominate most of your emotions, but at the same time let one small piece of you prepare for the worst.” I argue that developing your Plan B is that small piece; once you have that created — and ready to be implemented when necessary — you can enjoy the good times…while they last.

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