This article is by editor Linda Vergon.
As J.D. Roth put it, “Failure is okay.” We all experience it, and we each have to figure out how to deal with it. Some people even study it. In fact, studying failure is a very productive thing to do. A stress-test can be used to study failure in a proactive sense. It can help predict how and when failure will occur within the confines of a safe, theoretical exercise. And I got to thinking. How can we use that idea to improve our financial situation?
It didn't occur to me until today, but my husband, Terry, has been stress-testing our finances for a long time. (Ha! I don't mean that he pushes the budget to the limit in the real sense. But to an engineer with an MBA, it seems that life provides all sorts of scenarios just begging to be analyzed.) He is constantly tinkering with the numbers to glean insights.
What can a stress test tell you about your finances?
What do you want to know? Basically, the purpose of conducting a stress test is to help you recognize situations that would cause you to fail financially so you can try to avoid them before they happen. But you can use it to help plan your future as well. You might consider it to build a margin of safety around your investments, determine when to refinance your mortgage, or nail down what kind of car to purchase. It operates like a personal fiscal barometer, and its only limit is your creativity.
How do you stress-test your finances?
The type of stress test you develop depends on what you're trying to study or prevent. But if you're familiar with spreadsheets and a few simple formulas, you can build a working model in a few hours. If you want to know if you could weather the perfect storm, for instance, you can build a spreadsheet that models your income and expenses so that you see your disposable income every month. (If you have worked out your budget, then use that as your basis.) To stress-test your finances, increase your expenses or decrease your income and watch how that affects your bottom line. You can build it from there to answer more specific questions such as:
- How long can I live at this level of income without going into my savings?
- Can I afford to live here for the next five years?
- If my income goes up, how quickly can I address my debt or reach a savings goal?
We all make mistakes. Of course, we need to learn from our mistakes. But if we can study and learn to prevent mistakes, so much the better.
Do you stress-test your finances? If you do, what questions are you looking to answer and how do you build the test to model it?