Fair Isaac & Co. is tweaking their methodology for computing an individuals FICO score in 2008. As you may already know, your score affects the rate you pay on loans (mortgages, auto, credit card); but you may not know that your FICO score is now frequently used by auto insurance companies, employers, hospitals, and others.

It’s more important than ever to ensure you have the highest FICO (credit) score possible. The typical recommendations for improving your score are:

• Avoid using too much of your available credit card debt
• Remove errors on your credit report (get reports free at www.annualcreditreport.com)
• Avoid making late payments
• Shop for auto/mortgage loans all during the same month
• Maintain old credit card accounts and if necessary, use them on occasion to keep them open

However, there are additional recommendations given what we know about the new scoring methodology:

• If you’re an authorized user on someone else’s credit card, you need to drop that and get your own card. FICO will no longer count authorized users toward good credit.
• Try to have a mix of loan types on record. You should have a better score if you have installment loans (student, auto, mortgage) and revolving accounts like credit cards.
• Pay your bills on time! More weight is being placed on billing issues (delinquencies) compared to the old FICO calculation method.

There are of course other credit rating systems out there, but these systems (including FICO) are all black box calculations that look at similar factors. Most of this work to repair or protect your credit is pretty straightforward, and if you maintain good habits around debt you’ll be in good shape. For those with problems, you will have to be patient since improvements take a while to “stick”; don’t be tempted by quick fixes or credit repair firms!

As the first quarter of 2008 comes to a close, it is now a common time for people to check their investment performance and investigate new investment opportunities. If you look at the investment performance of various mutual funds (e.g. US large cap), many of them had terrible performance in 2001 and 2002 (even when compared to what we’ve experienced these past few months).

Beginning with 2008, advertised 5-year performance figures will not include these “spurious” old returns. Caveat emptor…

Me too! Just trying to figure out what’s happening with regulations and disclosures will only further confuse you, but here’s a list of keywords to google later: Merrill Lynch Rule, RAND Report, Cutting Through The Confusion.

There are various lobbying efforts, lawsuits, etc happening because they (huge brokers, investment advisers, consumer groups) all want a share of the “pie”. I think the main reason for the confusion has to do with politics and capture hypothesis in regulation, with the result being that this battle may never end until the structure of the financial services industry changes (and that may not happen in my lifetime).

So what is the take-away? It’s actually quite simple: A consumer must continually ask a financial services provider (broker, financial consultant, etc) if they are providing advice and service as a fiduciary.

In our industry, a fiduciary must advise and act in a client’s best interest, while a non-fiduciary must advise and act in a manner deemed suitable. Obviously, from a client perspective, suitability is a lower standard.

Now the problem is that some folks out there state that they sometimes provide services and advice according to the suitability standard, and sometimes according to the fiduciary standard. And if you follow the rule above, it makes for difficult conversation if every other question you ask is “are you acting as a fiduciary right now?”.

Let me be the first to propose an easy solution to all these lawsuits and convoluted regulations: When services and advice are given under the fiduciary standard, the person has to wear a bright green button on their collar; when given under the suitability standard, the person has to wear a red button on their collar.

And on the phone, two different tones can be added to the line in a similar fashion to the familiar “beep” you hear when somebody calls you on a recorded line. A website could have a small green or red flashing image in the top right corner of the web page.

So if you’re working with a guy that is constantly switching buttons, or you hear a melody of tones on the phone line — you’ll surely know you’ve got a flip-flopper on your hands.

That’s it, problem solved!

For those that have brokerage accounts with Bear Sterns, they may be wondering if they will get all their money back due to the near bankruptcy and recent buyout proceedings. Luckily, there are insurance and regulations set up to protect individual investors in many, but not all situations.

Bear is supposed to keep individual account holdings separate from their operating holdings, but if you lose funds due to negligence or misappropriation of funds you will likely be covered by $500,000 of SIPC insurance. This insurance does not protect investors from fraud or market related investment losses. Also, certain “exotic” investments like futures contracts and other derivatives may not be covered.

It’s important to note that FDIC insurance is completely separate and operates in a slightly different way. To find out more on SIPC check with your custodian and research the details here. Custodians/Brokers often carry additional insurance to cover accounts beyond the SIPC limits - yet another issue that should be checked on.

Time and again you hear on the radio or TV, the market is up 100 points, down 250, “hitting a ceiling at 13000″, or some other jargon — what does all this mean and should it mean anything to you?

Often the media refers to the Dow Jones Industrials Index when they refer to the stock market. I think this is very misleading, and serves their interests better than it serves the general public. Here’s why:

The “Dow” is a price weighted list of 30 arbitrarily chosen stocks that are supposed to represent the stock market. This price weighting means that McDonald’s has more influence on the index movements (recent price $56.05) than Microsoft (recent price $27.84) — even though Microsoft is a $265 billion dollar company and McDonald’s is a $67 billion dollar company by market cap. Strange isn’t it? There are several other problems with the index cited in this paper.

The index itself is very easy to calculate at various times throughout the day. This is why radio and TV loves it so much - it’s a catchy story to tell about the minute by minute changes in the “market”.

When the Dow Industrials Index was created over a hundred years ago it may have provided a good representation of market performance. Now that many investors have globally diversified portfolios in investments of various weights and market capitalizations — and are interested in total returns, the Dow should no longer be the benchmark of choice.

Many of you may remember the Beardstown ladies, a 14-member investment club from Beardstown, Illinois, who wrote books about how their common sense investing style made them amazing returns (see an old Time article on the subject).  It turns out their published 23.4% returns were actually 9.1% after an accounting firm audited their records!

Better yet, what about those cable shows called something like “Flip that house” where people claimed ten’s or hundreds of thousands of dollars in gains. 

Why aren’t people like us making that kind of money?!

I think there are many good take-aways from these examples but here are two: 1. Don’t trust rates of return people brag about; and 2. Most people don’t know how to calculate their actual rate of return. 

Let’s take a hypothetical house flipper who buys a run-down home for $200k, fixes it up with $60k over three months, then lists and sells the place in 90 days for $360k.  Sounds like an easy $100k doesn’t it?  You might say that’s a 38% return ($100k profit / $260k investment), but that’s not the entire picture.

Lets assume they put 20% down, get a great interest only mortgage rate pegged at 5%, pay closing costs of 7%, and pay cash for the upgrades.  Lets do the math and look at the cash flows:

1. In Jan, they pay $40k cash down payment, $20k house upgrades and interest of $667 ($160k loan * 5% / 12 months).
2. In Feb, they pay $20k house upgrades and interest of $667.
3. In Mar, they pay $20k house upgrades and interest of $667.
4. In Apr, they list the home for sale and pay the interest of $667.
5. In May, they pay the interest of $667.
6. In Jun, they sell the home for $360k, payoff the $200k mortgage, pay closing costs of $25k, and interest of $667.

That’s a rate of return of 6.18% (IRR), and if they did the same project for the next six months their annual rate of return is a decent 12.35%.   A far cry from the 38% above however!

I often have many personal thoughts on financial planning issues and would like to share them — so I’ve created this blog as a means to record these little “nuggets” of information. My posts may eventually interest a variety of people and although I may mention issues relating to money and finance, I have no intention of ever including investment advice on this blog.

Cheers!