Can you pass a financial stress test? Are you able to keep your standard of living after a layoff, a large medical bill, or a losing investment?
The best ways to pass a stress test are to reduce debt and to increase available assets.
Last week, I gave you specific ideas about which kinds of debt to reduce, and how. This week, I will teach you ways to buttress your assets in case of emergency.
To pass a stress test, assets need to be liquid, meaning you can access them with no penalty or delay, with little to no risk. Real estate is inappropriate, as it may take a while to sell, and as we've all seen, it's not a conservative investment. Stocks are also unsuitable: while you can quickly sell them, they certainly carry risk. Long-term certificates of deposit (CDs) are also inappropriate: they are FDIC-insured (up to $250,000), but they often carry hefty early termination penalties. Finally, be careful of some types of bond mutual funds: they usually pay higher interest than bank accounts, but are not insured (even if you purchase them through a bank), and may face significant losses when (not if) interest rates rise.
The best choices for emergency assets are usually invested in checking and savings accounts; money market funds; short-term CDs (maturing in three months or less); and mutual funds investing in shorter-term, high-quality bonds. By way of example, my wife Grace and I use a combination of money market funds and short-term bond mutual funds as emergency assets. The money market funds are FDIC-insured; the bond funds are not, but their historical fluctuations are so slight that we don't worry about them.
How much should you have in available assets to pass your stress test? I suggest using a multiple of months of expenses. For example, if you have no dependents, and your job is secure (or as secure as any job is in this economy), it's probably sufficient to keep three months' worth of expenses available. So if your monthly bills are $4,000 (rent, food, insurance, etc.), then you should have easy access to $12,000.
On the other hand, if you have dependents (whether kids or parents) who financially rely on you, or if your job situation seems shaky, it would probably make sense to raise your emergency savings to six, nine, even twelve months' worth of expenses.
Obviously, this is easy to write, but hard to carry out. Whether you need three or twelve months of savings, it can be tough to amass the funds. Here are some tips:
* Lower expenses. This is an intellectual no-brainer, but difficult to carry out for many people. Like dieting, it involves time, motivation, and willpower.
* Stop pre-paying your mortgage. While you will have higher interest charges over time, it will more quickly build up your emergency fund.
* Stop making contributions to your retirement and stock plans at work. These plans are terrific for building your net worth over time, but I suggest it's more important to cover your bases first.
By erasing much of your debt, and creating assets to draw from in case of emergency, you've gone a long way to passing your financial stress test.
Lou Dagen is a Certified Financial Planner in the San Francisco Bay Area. For 23 years, he has helped clients around the world retire in comfort, educate their children, and increase their net worth. If you have questions, please post them in the comments below or call Lou directly at 925-997-8507.