What a difference 10 years make. In the fall of 2008, the United States was in the middle of the largest recession since the Great Depression. Little did we know, but things were about to get much worse before getting better.
Today, things are better—at least financially. Unemployment is at a 10-year low, and the S&P 500 has posted double-digit returns for five of the last six calendar years.
Now, I can’t predict when the recession will begin. And I’m certainly not going to lure you in with some scary click-bait headline like “An 80% stock market crash is weeks away.” (Sadly, that’s a real headline I just read).
But I will remind you that the economy is cyclical—and we’ve had a good run. You can verify those cycles by picking up any respected economics or investing books.
I’ve also now lived long enough to experience it for myself. When I started college in 1999, I thought I was coming of age in the golden .com era and would graduate four years later into a six-figure starting salary at an internet company. By the time I gradated, I was lucky to find a job at all…and it paid less. Way less.
I don’t know what’s going to cause the dominos to fall. But what I do know is that things are bit hot right now. An S&P 500 index fund I bought near the market low in 2009 is up 325 percent. (Too bad I didn’t have more money back then). My local real estate market is reaching crazy levels again. I know people who have sold homes for 50 percent profits over just a few years. I also know people who are trying to fill open jobs and can’t find a warm body, let alone a highly-qualified candidate.
This won’t go on forever.
I’m not writing this to be all doom-and-gloom. Instead, I want to encourage you to take an honest look at your current financial situation and ask yourself: “Would I be OK if X happened?”
Let’s call it your personal finance stress-test. Stress-tests were a big thing back in 2008 and 2009s as banks had to prove to the government they had enough cash-on-hand to weather the recession without putting deposits at risk.
For us, it means making sure we’re using the good times to prepare for the not-so-good times.
Lifetime wealth is the result of many good decisions made over a long period of time
Nobody’s perfect, so you won’t get everyone right. I certainly had my screw-ups. If, however, you consistently make more good money decisions than bad ones, your net worth should improve over time.
On average, this isn’t difficult. You simply need to live within your means and get in the habit of setting aside some percentage of your money that you don’t touch for emergencies and retirement. There it is! In that last sentence, I just saved you from the need to read another word or financial advice for the rest of your life! I’m kidding, of course.
I believe, however, that we’re most at risk of making bad decisions when things get either very bad, or very good.
Bad times lead to bad decisions
It’s easy to imagine how falling on hard times can lead you to make poor money decisions. If you suddenly lose your job, you no longer have money coming in, but life doesn’t stop. You still need to pay the bills, but you also still have plans. You may not want to cancel a vacation or a previously planned large purchase, so you go ahead anyway.
Then, things get bleaker financially, so you find yourself turning to credit cards, just until you get back on your feet. Then, one month of a carried balance becomes six months, which becomes a year. Suddenly, you’re in serious debt. Then, perhaps you cash out a 401k to pay off the credit card, paying an unnecessary penalty and wiping out years of savings.
Don’t let good times lead to bad decisions, too
But how are good times dangerous? If there’s plenty of cash to go around, wouldn’t I just be making more progress toward my financial goals.
Hopefully, but that doesn’t always happen.
Let’s say times are good. You’re settled in a well-paying job that’s paid out bonuses for the last two years which you’ve used to pay off debt and buy a small rental property with a good tenant that’s cash-flow positive by a few hundred dollars a month. Not only that, but your significant other has a good job, too, and you’ve halved your living expenses by moving in together. Back when things were leaner, she started a side business that’s now making an extra five-figures a year.
Over the last couple of good years, you’ve done some things right. You paid your debts, invested in the rental property, and increased your 401(k) contributions. You have extra cash in savings, so you’re not really worried about emergencies.
Once you hit those milestones, complacency set in. You got fat and happy. You became used to not just having enough money, but more than enough money, at the end of the month. Not surprisingly, lifestyle inflation began to take hold.
Between extra vacations, more frequent restaurant meals, shopping at higher-end stores, and a payment on a new car, your monthly expenses have grown by 50 percent. It’s OK though, you think, because you’re saving each month and there’s still cash left over.
Of course, you should celebrate financial success. If you can’t take a nice trip with part of a bonus or treat yourself to a big purchase when your business takes off, what’s the point of all the hard work?
However, what were once splurge purchases can, if you’re not careful, become routine purchases. It’s surprisingly easy.
While that may be OK as long as things are looking up, you have to keep downside in mind. In this scenario, what would happen if—within the span of six months—you lost your job, your tenant moved out and the income from your partner’s business declined? Would you be able to make ends meet?
With all the extra spending, the odds aren’t good. How long before your emergency savings dry up and you need to sell the new car or unload the rental property if you can’t find a tenant fast enough?
This is the kind of situation nobody thinks will happen to them. Yet, it happened to millions of Americans ten years ago when the homes they borrowed against lost half their value.
This is why you need to give yourself a stress test before it’s too late.
The Stress Test
Giving yourself the stress-test isn’t difficult if you’re organized. You might, however, need a bit of time to gather your expenses. You may also discover action items that will take a bit longer to complete.
If you’re married or live with a significant other, you’ll want to do the stress test together. If you live together, your financial fates are intertwined, even if you merely split the rent and cable.
Chances are, you’ve already done something like a reverse stress-test when evaluating a new job offer. You figure out what you’re going to be earning at a new job after taxes, and what it’s going to look like for your budget. If you’re earning more, you begin to imagine how much more you’ll be able to save or what new things you can afford.
The stress test is less fun because you’re going to be looking at what happens if your income is reversed. I promise, however, that if you do the test and take steps to improve your score, you’ll sleep better at night for the foreseeable future.
Step 1: Determine your monthly required expenses
The first step of the stress test is an exercise everyone should do at least a couple times each year. We tend to be the most aware of our expenses when money is tight. As we grow more comfortable, however, we become less aware of how much we’re actually spending because there’s more of a cushion. Tallying your spending over the last year can be an important reality check.
Avoid the temptation simply to look at last month’s bank and credit card statements, as you’ll miss many irregular expenses like insurance premiums or tax payments that need to be factored into your average monthly expenses.
Once you have your average monthly expenses added up, you may decide to trim a few that are truly luxuries. These are things that you could quickly cut if the situation required it. Here are a few examples things you could get rid of:
- Premium cable channels
- Meal delivery service
- Other weekly/monthly subscriptions
- Vacation savings
Step 2: Check your emergency savings and other liquid assets
You do have an emergency fund, right?
Great. Now’s the time to check your balance and calculate how many months of the required monthly expenses tabulated in Step 1 your savings will cover. Although it’s great to have any amount of emergency savings, your ultimate goal should be to have savings that will cover at least six months’ of expenses.
Next, consider any other liquid assets you could tap if you had to. Do NOT count retirement accounts, home equity, or cars or other assets that you would have to sell. Taxable investments are OK, as are savings accounts that might be earmarked for other specific purchases.
Step 3: Determine your unemployment benefits
In many cases, you may be eligible for state unemployment benefits if you’re laid off or otherwise terminated without cause. You won’t be eligible if you’re fired for cause, such as chronic tardiness or stealing. Typically, unemployment benefits are only available to W-2 employees, not contractors or self-employed individuals.
Unemployment benefits typically covers a portion of your earnings for a set period of time. While you may not be able to determine the exact amount and duration of your benefits, your state’s labor department website should be able to give you an estimate of how much you might receive, and for how long.
Finally, consider taxes. Unemployment benefits are taxable, even if taxes aren’t withheld at the time of payment. Ouch, I know. It’s a good idea to reduce your expected unemployment benefits by 20 percent or so to cover the tax bill you’ll owe Uncle Sam in April.
Step 4: Look at your worst-case-scenario
Consider this: The economy tanks and your employer lays you off. Other companies are facing similar fates, so it’s going to be a long road to find another comparable job.
You need to file for unemployment and you may need to tap your emergency savings simply to meet your minimum monthly expenses.
Determine how long your unemployment benefits will last
You goal now is to determine how long you can meet your monthly financial obligations using unemployment benefits (if available) and your emergency savings. If your estimated monthly unemployment benefits are more than your monthly expenses, great! Add any surplus to your available emergency savings. If not, you’ll need to withdraw the difference from your emergency fund.
Unemployment benefits don’t last forever. Once they’re used up, you’ll have to pay your living expenses with your remaining savings.
After a bit of math, you should know exactly how long you can make ends meet in the event you lose your job and can’t quickly find a new one.
In this example, a $30,000 emergency fund and six months of unemployment benefits at $1,500 a month can provide just over 16 months of spending $2,400 a month.
How long should you be able to go?
After finishing the stress test, you should either feel relieved that, even in the worst case scenario, you’ll be able to financially sustain yourself for a decent period of time OR see it as a wake-up call to trim your expenses and increase your savings.
Only you can determine just how many months of savings is a comfortable buffer (when augmented by unemployment). I would argue that you should want to be able to survive at least a year. Anything less than that, to me, would be cause for concern. And again, to me, two years or more would be ideal.
Don’t freak out if you’re still working on your emergency fund and this test shows you wouldn’t last very long. This test is designed for people who have several years of solid earning and, hopefully, steady saving under their belts.
If you do meet those criteria, let this test serve as a reminder that stuff happens, and you want to be prepared. You might just discover that adding a few more months to your stress test’s bottom line becomes more important than throwing more money around to impress your friends each month.
Of course, hopefully you’ll never need to actually do this, in which case, you’ll just have more money in the bank and more money to throw around. Here’s hoping.