In the months since the Silicon Valley Bank collapse, we have all learned more about bank stress tests and how these tests protect our financial system from banks taking extra risks. I was thinking about how this might apply to our personal finances. Can you pass a personal financial stress test?
As financial planners and advisors, it is our job to be worriers. We worry about market downturns, clients panicking and abandoning their investment strategy at the wrong time, or the prospect of someone losing their job, or becoming disabled or dying. The list is endless.
That said, we also worry about our clients not reaching their goals, because their worries paralyze them. Our job is to help find a balance between being cautious and, at the same time, taking reasonable risks to achieve goals.
Finding that balance involves assessing risks, asking “what if” questions, and looking at potential outcomes and ways to mitigate risk. Of course, none of us can know the future, but we CAN stress test our financial plans.
What if my company stock drops?
All too often, employees are over-concentrated in their employer stock. This can be because they are awarded restricted stock as part of their compensation, or they participate in the Employee stock purchase plan, or they receive profit-sharing contributions in the form of stock. Whatever the reason, single-stock exposure carries a much higher risk than almost any diversified portfolio of stocks. A single stock can drop by more than 40% and do so very quickly. Examples abound- environmental disasters (ExxonMobil, BP, Union), issues with products (Merck, Boeing, Firestone), or fraud (MCI, Worldcom, Enron).
Stress Test: Assess what percentage of your financial wealth is tied to the single stock and engage in prudent selling to limit the exposure. Our rule of thumb is to keep exposure below 25% of your portfolio if you are young and working or 15% if you are nearing retirement.
What if my partner/spouse dies?
If a breadwinner for a family dies, it is nothing short of emotionally and financially catastrophic. The expectation of their lifetime earnings is lost. Earnings potential is highest for young professionals with many years of employment ahead. This earnings potential declines as we age, as fewer years of earnings need to be replaced.
Stress test: The simplest solution is to have adequate life insurance, which can be purchased at a low cost in the form of term insurance. Compare what insurance you have to what you need. It is best to have your own individual policy rather than rely on your employer group coverage in case you lose your job or become uninsurable in the future. Not sure what amount you need? Consult a financial advisor who does not sell insurance or an online resources (policygenius link).
What if I’m disabled?
Disability can arguably be even more devastating than death. Consider what you would need in after-tax dollars to support your household expenses.
Stress Test: What disability coverage do you have through your employer? Is the benefit pre-tax or after-tax? How does it compare to your current net income? How will inflation impact your needs in the future? Options are to buy more disability insurance through your employer or add a private policy.
What if I lose my job?
Recent examples of widespread layoffs (META, Twitter, Zoom) are a reminder that jobs can be lost suddenly without notice. This stress can be reduced by having an emergency fund. Our advice is to understand your monthly spending needs to build an emergency fund that can sufficiently protect you while you are looking for a new job. Understanding your spending is the first step to controlling spending if and when the time comes, and you need to “hunker down.”
Stress test: Do you have three to six months’ worth of spending needs in an emergency fund? It should be in a liquid, accessible, low-risk account, like a bank deposit, money market fund, or low-risk short-term bond fund.
What if my furnace/car/roof/ has to be replaced?
While unexpected expenses are, by their nature, unplanned, most of us will admit that certain types of expenses aren’t really that unexpected. We know our houses and cars will need repair, even though we may not want to face the facts. As part of our financial planning, we tell clients to budget 1% to 2% of the value of their home(s) for maintenance. Some complain that is too much, but if you look back at what it takes to maintain a house—it might be too low! We recommend keeping at least 1 year’s worth of home maintenance costs set aside as part of your emergency fund.
Stress test: Do you have enough in your emergency fund to cover 1% to 2% of your home annual cost? If your home is worth $500,000, that would be $5,000 to $10,000. If it is worth $1 million, keep $10,000 to $20,000. If your house is older, double the amount.
What if I’m retired, drawing on my portfolio, and the market drops?
Once you are retired and the paychecks stop, a drop in the value of your portfolio can be particularly unnerving. We approach this question by first understanding your withdrawal needs. That’s because the riskiest assets – stocks – need to have the longest time horizon of preferably more than five years. Short-term withdrawal needs should be met by holdings in lower risk assets such as money market funds, or high-quality government bonds. Stock investments which are higher risk and higher return are needed to combat inflation and the erosion of purchasing power, as retirees may have 30 years to cover.
Matching withdrawal needs to your portfolio strategy is step one. Step two is to stress test the portfolio against a variety of market environments. That’s where Monte Carlo simulations can be helpful. Our financial planning program takes your pattern of withdrawals and tests it against 1,000 potential market returns and inflation scenarios to see how many times the portfolio is exhausted and when. From this stress test, we can judge whether you need to adjust how you are invested, or if you need to reduce/increase spending.
Stress test: Most individuals don’t have access to planning software that can perform Monte Carlo simulations. Ask your financial advisor if they can run a stress test for you. If you are looking for a fiduciary financial advisor, use the Fee-Only, NAPFA, and CFP referral sites.
Alternatively, ask yourself, what would happen if the stock market were down for five years? Do you have five years’ worth of portfolio withdrawals in money market funds or lower-risk bond funds? If you do have enough in money market and lower-risk bonds, then you will be able to wait five years for the market to recover before you have to sell stocks.
What if I can’t access my bank account/credit card/brokerage account?
The SVB collapse reminds us that exceeding the FDIC limits is perilous. But in addition to bank failures, keeping sizeable cash balances is also dangerous from the standpoint of cybercrime. Criminals are looking for idle cash because it is the easiest to steal.
The reasons why you might be blocked from using a financial account might not involve a major bank failure. It might be far more mundane, such as identity theft or fraudulent use of your account. Nevertheless, it can come at a very inconvenient time. Recently I wrote a check for $2,000, which someone else deposited via mobile deposit but keyed in the wrong amount of $8,000. It took ten days for the bank to restore the $6,000 that was erroneously withdrawn, even though the person who made the mistake promptly tried to correct the error. There’s no way to protect oneself from all the potential problems, but having more than one credit card, and more than one account from which to access cash, is a good idea. Staying below the FDIC limits is just good common sense.
Stress test: What would you do if one of your credit cards were shut down or if you couldn’t access your bank account? Do you have a backup account or card? Are any of your bank accounts over the FDIC limits?
Doing a personal financial stress test at a time when you least need it will reduce your stress in the long run.