Single Point of Failure Financial Plans

[Note: This is a guest post by Shadox who writes the blog Money and Such. Money and Such is a blog about personal finance, career, career development, economics and general life commentary.]

Many people live at the edge of financial disaster. In most cases these people don’t realize the precarious nature of the financial situation in which they are placing themselves and their families. They believe that they are being responsible and living within their means, when in fact, they are building a house of cards which will collapse at the first sign of trouble. Their financial strategy is not a robust one, since they rely on the assumption that everything will continue to go well. These are single point of failure financial plans: all it takes to disrupt them is a single unexpected incident.

I have been doing a lot of thinking about this issue as part of our ongoing hunt for a new house. I see many people around me who make less money than I do, and are capable of making much smaller down payments, yet go for bigger, more expensive houses than I would ever consider. In many cases their plan appears sound: maybe both spouses are working and can easily make the house payments; maybe they think that the house is a good investment and will appreciate in value; maybe they expect their income to grow. The plan may currently be viable, however is the plan robust? That is, how much disruption can the plan take before it falls apart? Is there a single cog that can bring down the whole financial machine when it breaks? Is there a single point of failure?

In the case of our proposed house purchase I ask myself the following questions: will we be able to make our payments if I lose my job? Will we be able to make our payments for an extended period if my wife is unable to find a well paying job? Will this plan still be viable if a member of the family gets seriously ill or injured (God forbid)? The point is this: you never know what tomorrow will bring, and while a bigger yard and an extra bedroom is nice, having financial peace of mind is much, much nicer.

Robustness, i.e. resiliency in the face of adversity should be a primary goal of any financial plan. To make your plan resilient you need to take three steps: identify the risks; eliminate all risks that can be economically removed and mitigate others; and finally, plan for how you will deal with unmitigated risk. A plan is only sound if after you have taken these three steps you are capable of withstanding the remaining risk or are willing to live with the consequences. Let’s briefly look at these three steps:

Identify the Risks – naturally, you can’t identify ALL the risks and even if you can, there is not much point in doing so. Some risks are very remote, and others you can do very little about, but at the very least, make sure that you understand the major components of the risks that can disrupt your plan. In the case of buying a house, loss of income is a big potential risk; loss of the house due to a natural disaster is another; and so forth. Once you think you understand the big things that can go wrong, move to the next step:

Eliminate & Mitigate Risks – some risks can be largely eliminated through the miracle of insurance. For example, since we live in earthquake country, I would not consider buying a house without also buying earthquake insurance. The risk of losing the house to an earthquake, without having the financial resources to rebuild is simply unacceptable to me. Yet, the number of people who live in California and choose not to insure their houses against earthquakes is astounding…

In some cases it is possible to simply avoid the risk altogether. Moving to another state to buy a house might not be feasible, but making sure that the house you are buying is located on higher ground such that it doesn’t get washed away in a flood may be possible.

Plan for the Remaining Risks – it is impossible to eliminate all risk. I would love to insure myself against loss of my job, but unfortunately such insurance does not exist. Making sure that I don’t come down with some serious health condition is likewise not within my reach. There are many other similar examples. The point is that if you cannot eliminate the risk, you must plan for it.

For example, I can’t make sure that I won’t lose my job, but I can make sure that we will only buy a house if we can continue to pay the mortgage for a considerable period even if I am unemployed. The plan must be robust to at least one or two major disruptions. Hence, under our financial plan we carry health insurance (robustness in the event of a major illness), we make sure that we can support ourselves on a single income (resiliency in the case of unemployment), we have sufficient, safe and liquid assets that we can tap into if all else fails (a fall back in unforeseen circumstances) and so forth. You get the picture.

Accidents, disasters and unforeseen events will happen. The question is: is your financial plan robust enough to withstand them or are you running a plan that has a single point of failure.