I recently wrote about our experience on our first cruise. Of course I couldn’t help but come up with at least one cruise metaphor post for you to suffer under, my apologies in advance. Today we’re going to be talking about a financial fire drill.
A Cruise Fire Drill
The first day of a cruise you go through all sorts of hurdles to get on the boat. Customs, Immigration, and check in, it’s like a never ending line. Just as you get to your cabin and are ready for a long rest, they spring one more thing on you. A practice fire drill of sorts to ensure you know where to gather in case of an emergency.
It’s a bit nerve racking to be honest. You get on the boat and go to your interior stateroom, with no windows I might add, after waiting 2 hours in line to get on board. Then 5 minutes after you get to your room they call you to a gathering point for an emergency. You are thinking if it takes me 2 hours to get to the meeting point I’m going down with the Titanic!
The reality is though the whole thing is over in less than 30 minutes. It’s also critical to do, especially for the more neophyte among us who have no idea what to do if the boat starts sinking other than run around with our heads cut off and then jump into the sea. Being prepared in case of an emergency is important.
Financial Fire Drill
The thing is, there are all sorts of emergencies. Today I’m going to talk to you about one you might not have considered, a crashing economy. So many of us go through life either ignoring crashes or in constant fear of them. Just like the neophytes on the boat what most of us need is some sort of Financial Fire Drill.
Now before I go any further, don’t take this to mean I believe a crash is imminent. I have no more knowledge than anyone else, and if anyone tells you more than a crash will happen in the future (ie no timelines) they are probably just looking for publicity. Still it seems prudent with so much crash talk in the air to prepare for it.
What Happens in a Financial Crash
So what happens in a crash? Well first we have to start by defining one. There can be a few types and they are not always found together.
Defining A Stock March Crash
The first is a stock market crash. Basically defined as a sudden pull back in stock market prices, depending on whom you ask these can involve reduction in stock prices of anywhere from 10-50%. They can last anywhere from a few days to years. The net impact of these is, if you are invested in stocks, to wipe out large portions of your net worth in one go.
Defining a Recession
The second is an overall economy crash, also know as a recession or in a worse form a depression. A recession is generally a contraction in the business cycle resulting in a slow down in the economy. Most economists believe the economy goes in cycles of growth and decline on a regular basis. Hence a recession is considered a normal event. A recession is a widespread decline. How wide spread? Generally economists define a recession as two consecutive business quarters of negative growth, or about 6 months of time.
Defining a Depression
A depression meanwhile is basically a long term more severe recession. They are the abnormal exceptions, the black swans so to speak. In general the US government does not explicitly define depression, though many in economics define it as decline that lasts years. In any case the impacts of a depression and recession on individuals is much the same, though differing in duration and amount. As an individual it could be marked with potential job loss, wage decline, businesses going bankrupt, and other bad things for your income streams.
We’ve written in the past about preparing for a simple stock market crash. Create an investment plan with contingencies for if the market were to crash. Then ensure you follow it. The Financial Fire Drill here is to first revisit your plan and ensure it makes sense. Changing it during a down turn will likely result in you doing something stupid.
Test Your Plan
Then run a dry run. Take your accounts and reduce their funds on paper by 40%. Will you have difficulty paying your bills due to liquidity issues if this happens? When the answer is yes set aside more cash in riskless assets. If it remained at this level for a prolonged period of a year or more would you a) stay the course or b) sell everything locking in your loses. When the answer is b adjust your asset allocation to match your risk tolerance now by buying more risk-less assets (CDs, bonds, t-bills, i-bonds, etc) and less stocks. It’s hard to do this as a simulation without the emotions of a real event, but the same difficulty exists for a cruise fire drill if we are honest. We do what we can. If you are asking should I invest in the stock market now, then you are at the wrong risk tolerance.
Preparing for Job Loss
For a recession or a depression things can be worse. You could lose your job, experience wage loss, lose your business, etc. So you should ensure you can handle living for some period of time without your employment before you get there. Put in place contingencies like an emergency fund. Increase your savings rates why the going is easier. Have a plan on how you will use your emergency fund and what you will do if you do lose your job. Then, since I always believe in testing plans, pretend you’ve lost your job for a short period. Cut back your expenditures to the point of your contingency amounts and see if it’s doable. Again the key is to stick to it when things go sideways.
For Business’ Define an Exit Point
If you have a business you should have a defined exit point. That exit point should not only define when the business is enough of a success that you might sell it and retire to Tahiti, but also when would you sell it if it became a sinking ship that sucks up your funds. Going down with the business is a serious bad move, you need to know if/when you would skip out of the business. This can actually go both ways, it’ll keep you from canning the business too early due to the sudden irrational fear recessions often bring to the general public. But it will also keep you from holding on to it until it sucks up your last dime.
Next we have the dreaded combination of a recession and a market crash. They do usually go together, but as I noted not always. In this case combine all the items as per above to ensure you are prepared.
Prepping for Inflation
Finally, one more economic situation can adversely effect your path, inflation. Don’t forget about having a plan in place if inflation takes off. What investments would you invest in to allow you to respond to inflation quickly? How would you keep your expenses under control in an inflationary environment? These all need to be in your plan. You can imagine the impact of inflation on your spending by estimating budget increases across the board of 4-5%. What would you do if groceries were suddenly 5% more expensive. You need to know the answer before it occurs.
Financial Fire Drill According to Risk
Going back to our risk analysis post high likelihood and high impact risks are the ones you need to prepare to mitigate the situation. Ship Fires, I’m told are relatively rare. However, they can be catastrophic if you encounter one. The problem with Stock Market Crashes, inflation, and Recessions are they are not rare and they are impactful. They happen quite regularly as a normal part of doing business. So if it’s important for you to drill for a ship fire on a cruise, don’t you think it’s important for you to prepare with a financial fire drill?