Sep 13, 2014,14.05 IST
Three simple steps to stress test your financial portfolio
What do we mean by the term ‘stress testing’?
Stress testing is about demonstrating how a particular process balances in a condition, when you try to push the same beyond its usual operations. We can also state the same about a stress test in other words. It implies a condition, where you push your system into the crash mode and find means to recover from that. Demonstrating stability and coping up with the extreme conditions will be ideally equivalent to passing the stress test.
How does one stress test his personal finances?
Financial crisis are not just limited to the corporate sector and the overall economy. In our personal life too, we come across many situations that affect our finances, such as a job loss, accidents, health problems, rise in children’s school fee, etc. In unstable conditions like these, passing through a stress test lets one find out how well he/she is, to face and manage the period of financial crisis.
The stress test is a very useful technique to determine how our financial portfolio (that includes investment, insurance, expenses and income) will get along during a dilemma.
The following useful tips might help you deal with your uncertain conditions and have some stability in your life.
1. Make a checklist of your financial position in detail:
Your financial situation includes your total income (from all the sources), expenses, assets and liabilities. Expenses will cover details such as your monthly rent, household expenditures, children’s fees, holidays and vacations, etc. Also, include your financial and real asset details. Liability details will comprise of EMIs on personal, home, or car loan, etc.
2. Analyze questions pertaining to certain simulation scenarios:
One has to do some kind of brainstorming sessions with him/her, or with the family members, or stakeholders. One may also seek the help of his financial planner. This is to find out the different limitations. Some of simulation questions are as follows:
a. What percentage do the different income sources have in the overall income portfolio? In addition, what effect does it make to your personal finance if one or two of the income sources stop?
b. What is the percentage that different expenditure areas carry in your total expense portfolio, and how does it affects your finances if there is a sudden rise in one or two of the areas?
c. What is the situation of liquidity, in your assets portfolio, in case of emergency? An example of this could be a mishap and a celebration in your family, simultaneously. How does one manage his finances in such scenarios of sudden expenditures?
d. The last question is about how volatile isyour investment portfolio. What percentage of the different assets does one carry in the same? How will the portfolio affect, in case of stock market fluctuations, or government policy modifications?
3. Look for the best answer possible to simulation queries:
It is completely fine if one has sufficient amount of liquidity, appropriate asset allocation in investments, proper sources of income, and adequate insurances to rely upon. With all or any of these, one might not feel the pinch in any of the critical conditions and one can very easily pass the test. The situation becomes a cause of one’s concern if he/she does not have a comfortable answer to any of these.
What will happen in a case, where one cannot pass his/her own stress test?
Of course, one cannot go out to raise more capital. There are certain techniques for ratio analysis that help one determine the liquidity position of your assets, and many other things like the maximum debt one should take.
However, finally you are supposed to bring your finances into place and work out the situation. One can do this by,
• reducing overall spending,
• paying off big amount loans,
• doing a goal-based investment,
• following a well-defined approach for asset allocation,
• diversifying investments, or
• Setting up a credit line for emergency use.
You can definitely not wait for an unfavorable condition to occur, in order to perform a stress test. A volunteer stress test will help you in figuring out how much one will have, for how much time it will last, and where to seek help from if circumstances go beyond one’s control in hitting your family finances.
Therefore, it is always a good option to do a stress test for your own personal finance in order to manage the uncertainties with confidence. This will also prevent you from repeating the same mistake that others did, and rather take different approach learning from the same.
The author is Ramalingam K, CFP CM is the Chief Financial Planner at holisticinvestment.in, a leading Financial Planning and Wealth Management company
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