It doesn’t matter if a boxer has great stamina and knockout power if he has a glass jaw. One well aimed punch and the lights go out and that power and stamina mean nothing. In the same way, it doesn’t matter how great your income or investments are if you don’t have a solid financial foundation. Financial stability is the ability of your financial life to stand up under difficult situations and circumstances and continue to hold up everything that is built on top of it.
A solid financial foundation is one that can take a punch. You can think of this like padding. A football player wearing pads and a helmet can take a lot harder hit than one who isn’t. Financially this comes down to having some buffer. There are two primary types of punches your financial foundation needs to be able to take. You need to be able to take a knockout punch, a single punch that has a lot of power. You also need to be able to take a series of continuous smaller punches without getting worn down.
So how do you deal with these?
- Budget: You absorb the series of continuous punches by having some buffer in your monthly budget. Instead of taking on payments and bills that equal your income, leave a buffer. Even beyond just the amount you save and invest. That way if something comes up that increases your monthly expenses, you can absorb the increase (increase in insurance, additional children, ongoing health issues, etc.). Also, you can use this buffer to absorb the small unexpected expenses that seem to come up regularly.
- Savings: You absorb the large knockout blows by having some cash set aside for emergencies. That way if a large unexpected expense comes up, you can handle it without having to go into debt, raid your retirement accounts, or look to bankruptcy.
If losing a job, or missing a paycheck, or a small unforeseen expense causes everything to come crashing down, then you don’t have a very good financial foundation. Your investments may have been great, your business may have been strong, you may have been making good financial decisions otherwise, but a weak foundation can ruin all of that. If you have a large unexpected expense and don’t have the emergency fund to cover it, then you may have to sell a good investment, pull money out of a growing business, or worse.
The stronger and more resilient your foundation, the more investments you can build up on top of it and the more risk you can take with those investments without fear of it all coming crashing down because your foundation couldn’t take a punch.