How To Pass Your Financial Stress Test, Part 2

Are you able to keep your standard of living after a layoff, a large medical bill, or a losing investment? Learn how to save money and pass your own financial stress test.

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.

This post is contributed by a community member. The views expressed in this blog are those of the author and do not necessarily reflect those of Patch Media Corporation. Everyone is welcome to submit a post to Patch. If you'd like to post a blog, go here to get started.

Chris Nicholson January 22, 2013 at 09:56 PM
Yikes! Amass (up to) 12 months of expenses in cash via after tax dollars? And do this BEFORE putting money in assets that have any chance of positive real returns? That seems like a VERY tough proposition for most (90%?) people. It seems to me that the opportunity cost of NOT maxing out your 401(k) is too steep a "premium" to pay for the insurance policy of a big cash rainy day fun.
Lou Dagen, CFP, ChFC January 22, 2013 at 10:05 PM
Camaro, you're quite right. My suggestion to give up free money sounds ridiculous, especially after I strongly encouraged it in my blog two weeks ago. That said, there are times where giving up that free money makes more sense. As some examples: * Workers often know that layoffs are coming, and so building up their emergency reserves might be wise. * Your spouse/partner is pregnant and will take time off work to care for the baby. Your lower household income and higher expenses requires more cash on hand. * You really want (or need) to buy a home ... go back to school ... whatever the major expense. So Camaro, I agree with you on the importance of a corporate 401(k) match, but there are times where it doesn't make sense. Oh, and there's only a tax penalty for withdrawing money from a 401(k) before age 59 1/2. You can usually borrow up to $50,000 with no penalties in a real emergency. However, if you lose your job, most plans won't let you borrow, so that option is closed off. I still love your picture ... how do you kill one who has no life? :-) --- Lou
Lou Dagen, CFP, ChFC January 22, 2013 at 10:12 PM
Hi Chris, you're right, it *is* a very tough proposition. And there certainly is a lost opportunity by not making the 401(k) contribution instead. Nevertheless, there are situations where keeping a year's worth of expenses on hand makes sense. The classic case is a single earner of a household with dependents and high monthly expenses, working for a weak company, or in a shaky economy. With so many people relying on her resources, I'd advocate for a much higher emergency fund than normal. In contrast, a single person in his 20s or 30s, with no dependents and highly employable? Two to three months worth of expenses should be fine. One other downside of my approach is that the emergency fund is "dead money," in that in this period of low interest rates, the fund is probably earning little to nothing. It acts as a drag on your net worth. That said, I view it like paying insurance premiums: if you don't die / crash your car / get sick, it's wasted money. On the other hand, if bad things happen, you'll be very glad it was there. --- Lou
David January 23, 2013 at 02:41 AM
Yes, when you're supporting 4 people, perhaps not when you're a 25 year old single guy, who, if worse came to worse, could sleep in his car for a couple weeks. But then again, when you're sleeping in your car--perhaps that extra month of savings would have helped. As Lou writes, it's unemployment insurance essentially.
Zolla January 28, 2013 at 01:35 AM
The British Virgin Islands, Uncle Sam just hates those words. Never felt so secure in my life.


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