Are you prepared for the unexpected? What would happen if you lost your job? How long could you meet your expenses? Can you handle major car or home repairs? Have you even considered these scenarios? A financial risk test will help you answer these questions and more.
Why you need to do a financial risk test
In recent articles, we covered creating a net worth statement and a cash flow statement. These are important indicators of financial health, but they don’t give you a complete picture of financial health. They tell you where you are and where you are headed, but they don’t tell you how prepared you are for emergencies. That is why you need to do a financial risk test.
What is a financial risk test?
A financial risk test is one way to analyze your ability to handle financial emergencies. This includes looking at your overall financial situation, cash flow, employment situation, insurance, investments, and other factors that can effect your financial health and readiness.
How to perform a financial risk test
A financial risk test will help you analyze your financial situation and your ability to handle the unexpected. You want to consider everything that may effect your financial health and look at options to mitigate your risk when performing a financial risk analysis (insurance is only one option; more on that in a moment).
Each person will have different factors that effect his/her individual situation. For this exercise I have broken the financial risk test in to several major indicators that should be common to most situations: cash flow, employment, insurance, investments, and estate planning. Your situation may vary depending on your specific situation, so take some time to consider all factors that could effect your financial situation and plan accordingly.
Cash flow risk analysis
The first step is to create your net worth and cash flow statements as referenced in earlier articles. We will use the information in these statements to determine your cash flow risk. You will also want to pay special attention to your emergency fund which will help you answer these questions.
Ask yourself these and similar questions based on your specific situation:
- Can I handle a $1,000 emergency? (car or home repair, airline ticket to visit family, etc.)
- Can I handle a $5,000 emergency?
- How many months of current living expenses can I maintain if I lose my job?
Your answer to these questions will determine your next actions. If you can handle a $1,000 emergency, but not a $5,000 emergency, then you may decide to increase the size of your emergency fund.
Employment risk analysis
The last few years have taught us that there are few permanent jobs left in the U.S. Short of a government job or a tenured position, most people face some risk of losing their job.
Questions to ask yourself:
- How secure is my job?
- How likely am I to be laid off in the next few weeks, months, or year?
- What is the general outlook for my company? Industry?
- What about the local or national economy?
- Can I claim unemployment benefits if I lose my job?
- How long will it take to find a new job?
- Will I be able to to find a job with a comparable salary or will I need to take a pay cut?
Many of these factors are out of your control, but that doesn’t mean you cannot prepare for them. It is always a good idea to have a current resume and maintain your professional network. It also never hurts to work on new skills or obtain licenses or certifications in your field. Not only can they make your resume more attractive, but they may net you a raise as well.
Investment risk analysis
Analyzing investment risk is a broad topic with entire books and websites devoted to determining investment risk, asset allocation, diversification, etc. For this exercise we are looking at investment risk from a 30,000 feet view. Before we start looking at your investments from the perspective of a financial risk analysis, you will want to know how much you have invested, your asset allocation, and a clear idea of your investment goals. A good tool to help with this exercise is the X-Ray tool form Morningstar.com (you can register for a free account or a free trial to Morningstar premium if you are not already a member).
Questions to ask yourself:
- Do my investments meet my desired asset allocation?
- Is my asset allocation appropriate to my investment goal(s)? My age?
- Am I on track for retirement?
- Will I be able to retire if my portfolio drops 10% in value? 20%? 30%?
The best actions to take will vary depending on your answers to these questions.
Are you properly insured?
Insurance is another broad topic. For our purposes we want to see if you have not only adequate insurance, but the right types of insurance and the right coverage amounts. Again, your specific needs will vary. If in doubt, visit with an insurance specialist or financial planner who can help you with your situation.
- Do you have enough and the right kind car insurance?
- Do you have sufficient homeowner’s or renter’s insurance?
- Do you need general liability coverage?
- How much life insurance do you need?
- Should you buy term or whole life insurance?
- Do you need long term car insurance?
- Do you have the right health insurance for your needs?
- Do you need mortgage protection life insurance?
- Should you get pet insurance?
- Do you need umbrella overage?
You may find that you need to purchase more insurance, or you may find that your current level of insurance is more than adequate. Some people may even elect to self-insure to avoid paying insurance premiums at all.
Are you prepared for the death of a loved one?
This is the most difficult question to face, and there is no easy way to deal with the thought of a loved on passing on. But it is essential to prepare for the inevitable. One of the best ways to prepare is with an estate plan, which is an important and often overlooked part of financial planning. But it also helps to have a financial continuation plan and/or a list of instructions for carrying on your financial situation, business, or other asset.
- Do you have a will or estate plan?
- Do you have adequate life insurance?
- Do you have a financial continuation plan?
I recommend that everyone accomplish each of the items on this list. You can create a simple will for a few dollars through many online forms, or you can use a lawyer for a more complete estate plan. Your needs will vary.
Where to go from here
Performing a financial risk analysis forces you to ask some difficult questions and prepare for some even more unpleasant outcomes. No one wants to think about financial emergencies, losing his job, or death. But all of these events are not only possible, but probable at some point in your life.
Hopefully you will take the time to thoroughly complete this financial risk test. You will probably come up with some ideas that will better help you prepare for the unexpected, reduce your overall risk, and make improvements to your financial plan.