Stress test your financial plan
Are you aware of the shortcomings in your current financial plan? Here are seven questions to ask yourself.
It's the toughest test America's 19 largest banks may ever take. They will imagine the worst possible economic news and then calculate if they've got the money to cover their losses. No wonder it's called a stress test. They are trying to figure out:
- What happens if unemployment rises to 10.3 per cent?
- If home prices plunge 22 per cent?
- And if overall economic growth drops to negative 3.3 per cent?
Most important under these conditions is what will happen to the banks' balance sheets? What does the bank lose from increased defaults on mortgages, auto loans and credit cards? How much, if any, taxpayer dollars will the banks need to stay afloat?
It got me thinking - What will happen to me in a worst case scenario? What will happen to you?That's why it's a good idea to "stress test" your own financial plan. You should be aware of any shortcomings in your current plan. This is a simple test, but you may want to consult your financial advisor.
- Is your safety cushion big enough to break a fall? Just like the big banks, you should know if you're prepared for a worst case scenario. If you lose your job, or fall ill, you will need enough of a reserve to cover six to eight months of your living expenses. For extra cushioning you may even want to consider insurance.
- Can you reach your goals with your current plan? If you've read my column before, I assume you have a plan. It is essential. If you haven't checked your plan in a while consider what's happened in the last six months: Interest rates have fallen to almost zero, unemployment has soared, economic growth has stalled, and the market hit multi-year lows before roaring ahead almost 30 per cent. Your portfolio probably looks a lot different than it did six months ago. Ask yourself if your goals are attainable with your current plan.
- Are you saving enough? You may have made assumptions about the growth or yield from your investments. It's time to re-examine those assumptions. Perhaps they were made during the overly optimistic bull-run. If your portfolio has shrunk, or your projected returns aren't what you thought they'd be, you need to re-examine your savings plans.
- Do you have more debt than you're comfortable with? Many Americans got into trouble by taking on bigger and bigger mortgages during the boom. They rationalized since prices were rising by 10 per cent a year, they could always sell the house at a profit if something happened. Then the market went bust and millions of people were left to pay mortgages they could not afford. It's important to keep your eye on your debt. It's a good policy to pay it off as quickly as possible. Start with high-interest credit cards and move down the list to lower and lower interest rates.
- Is your asset mix appropriate? Do you have a blend of fixed income, equity and cash to help you reach your goals? The economic downturn may have changed your investment horizon. Perhaps you're now pondering an early retirement package, or maybe you think you might have to work longer than you had initially planned. Changes in your life can sometimes mean you should make changes in your asset mix. Consult your advisor and make sure you have a mix that's right for you.
- Are you over/under diversified? You want to spread risk beyond one company, one currency or even one country. Though the downturn has been global, the recovery can be uneven. You want to maximize your chances of participating in any rebounds. On the other side of the coin, you can be over diversified. Streamline your portfolio so you don't have multiple funds that cover the same ground, while fees eat away at your returns.
- Does thinking about your portfolio keep you up at night? Perhaps this is the ultimate stress test. You may have thought you were risk tolerant only to discover that you aren't. Work with your advisor to bring your goals, expectations, and your portfolio in line. If you can't sleep at night, you probably haven't passed one or more of the previous tests.
Your own personal stress test doesn't have to be stressful at all. In fact it could be just the opposite. It's easy to worry about the unknown. But by performing these tests, you'll know exactly where you stand. If there is no reason to worry, you can go ahead and relax. If there is a problem you can address it before it becomes a real issue. Either way, you know you'll be prepared.
MSN.ca Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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