MoneyMerc is dedicated to “little decisions” that make a big impact.  Our little decision for today is to make sure you know your financial worst case scenario.  These are uncertain times - but the time to plan for the worst case is before you are living it.  Of course everyone’s situation is different, and no one can predict the future… but the goal of this post is to get you thinking about your own situation to prepare you for the unknown.  Don’t get scared - get ready!

A short list of (probably) the worst events for your financial situation:

1. Losing your job (or spouse’s)
2. Death of a primary income earner in your family
3. Parents losing their job or income if they are retired (and start to depend on you)
4. An unforeseen immediate medical need, either of you, a family member or parent/grandparent
5. Other large expenses you didn’t plan for (a new child, natural disasters which you don’t have insurance for, etc.)

If any of these occur, in most cases the crux of the situation is cashflow.  Here are some things to consider:

What’s in your personal bailout fund?

Everyone needs a bailout sometime - unlike Wall Street, most people have to work it out for themselves.  Otherwise known as an emergency fund, your personal bailout fund should be easy to access, and 100% safe.  A bank savings account is a great place for this money, because you can walk into your bank on any given day and walk out with the cash.  Other forms of investments like stocks or funds are not good to use (you might be forced to sell when they are down) - ditto for anything that takes more than a day or so to get your money.  If you are lucky enough to have parents or family who can loan you money quickly, that is technically another option for you - IF you can look at yourself in the mirror owing them money.  But don’t relay on that if you haven’t previously discussed the possibility with them, because that wouldn’t count for knowing your worse case scenario.

How big are your bills?

Most people don’t have a full understanding of where their money goes each month.  Bills fall into two categories - those that are essential for living (mortgage payment, basic food expenses) and those that are non-essential but improve living (dinner out, starbucks, new electronics).  Make sure you know exactly what amount of money goes out each month to the essential (”non-discrentionary”) expenses.  It can be an eye-opening experience to divide your emergency fund total balance by your essential expenses.  Ideally this ratio will be 3 to 6 months.  Meaning if you lose your job, you can survive for that long.  With a job market like today, go for 6 months or more if you can.  If your ratio number is less than one, you should start worrying, and then make another little decision to start figuring out how to decrease your expenses.

If you are married and both work, then you should also ask yourselves if you can afford your required expenses on a single income.  Which leads us to…

How secure is your job?

Take step out of your cube, turn around, and look back at your empty desk.  What if you didn’t sit there anymore?  Carefully consider the likelihood of losing your job.  It’s scary to think about, but it’s also easier to work on skills and generally prepare for another job while you have a current source of income.  Think about what industry you work in, and the general stability of other companies in the same industry or of similar size.  Why is your company more secure than others, and why is your job more secure than the person next to you (or than even your boss)?  Is it really?  Keep in mind and try to avoid the human bias which makes us think we are better than we really are (watch the first few episodes of American Idol each season to understand how this works!)  And check out Get Rich Slowly’s 10 Essential Steps to take before you get laid off.

How much debt do you have?

I’m not so worried about mortgages and student loans here - but you should be well aware of how much you owe on your credit cards, and at what rates.  Paying off debt is your financial job #1.  But if you don’t have an emergency fund, it may be wise to start building one before paying off debt. But you definitely don’t want to be in a situation where you can’t afford even your minimum payment.

So what’s the next step?

Now that you’ve thought about your own situation, what is your takeaway?  What one thing can you do to make sure your worst case is a little less worse?  Do you need to get help with your debt?  Or just force yourself to remember to save by setting up an automatic savings plan?  Maybe start talking with your parents about the security of their own financial situation so you can better know how it may affect you?

photo credit - joelogon

(photo: Dave Malkoff)

An Exchange Traded Fund (ETF) is similar to an index fund - they are typically not actively managed and therefore (often) have low management fees.  Sometimes when you can’t find the perfect fund for your asset allocation, an ETF will fill that gap.  But ETFs aren’t good for regular automatic investments, because you pay a trading fee each time you buy or sell, just like you would in a stock.  Also, they have other supposedly good features which are useless to regular investors:  you can sell them short, and you can trade them during the day (rather than only once per day with a fund).   Because of these features (and marketing), ETFs have gained popularity in the last couple years, and the flavors available have proliferated.

In watching your portfolio drop in the last year, if you are like most people you are wondering where you can invest your money so it’ll go UP, not DOWN.  Check out the finance.google.com page on most recent days, and you’ll see on the “Top Movers” list is the “ProShares Ultrashort Financials ETF”.  On 3/13 it gained 10% when the Dow was down 1.7%, and I’ve seen it gaining 30% or even 50% in a single day.  So you’re thinking, wow, I need to get a piece of THAT!  It’s a perfect hedge for your portfolio, since when the rest goes down, this goes up… right?

Not so fast.  This ETF is part of a certain class of ETFs which are very risky, volatile investments and shouldn’t be purchased by regular investors like you.  These ETFs have words in the name like: “ultrashort, double, triple, 2x, 3x, bear, bull”.  Something that is “2x”, for example, is designed to return 2x what regular investors would get in the underlying investment (e.g. a “2x S&P500″ ETF will gain 2x the S&P on up days, and lose 2X the S&P on down days.)  How do they do it?  All of these ETFs employ “leverage” to give the prescribed return profile, which means they borrow money so they can invest more.  It’s like investing on margin for regular investors - say you have $1000 to invest, but can borrow another $1000, allowing you to invest $2000.  So that when it goes up 10% to $2200, you give back the $1000, and made $200 or 20% (minus borrow cost) on an investment that only went up 10%.  On the flip side, if the investment goes down 10% to $1800, you still have to give back $1000 and now lost 20% (plus borrow cost) on an investment that only lost 10%. (Lesson: don’t invest on margin.)

Okay you say, but what if I use one of these as a small PART of my portfolio, as a hedge (like owning stocks and bonds together - one goes up, the other down)?  As Jason Zweig from the Wall Street Journal writes, this strategy can (will) backfire.  Due to the large swings in daily holdings values, leveraged ETFs are not designed as long-term investments.  They are for day traders, not investors.  For one example, on Friday the lovely ProShares UltraShort Financials had 31.92million shares traded - but it only has 6.8 million shares outstanding!  This implies an average hold time of 86 minutes.  The article quotes Andy O’Rourke, marketing chief of Direxion Funds, an ETF manager - holding a leveraged ETF longer than a day is “like using a toaster to cook a turkey.”

As usual in investing, you will be rewarded by sticking with the basics and not experiementing.  Reducing ‘oops’ moments will make you richer.

Have any thoughts on ETFs?  Please tell us about it in the comments.

Last year I attended an FPA session on improving your credit score by Oksana at StrategyCredit.  Here are some things I learned, many of which most people don’t know.

Your credit score really just measures the chance you’ll pay someone - essentially how much of a financial risk you are.  They are used for everything from apply for a credit card or mortgage to getting auto insurance or even a job.  A high score means (the credit agency thinks) you have a high chance of paying your bills/loans.

The FICO score, created by Fair Isaac Corp in 1958, is the leading credit score metric.  Here’s what different scores mean:

Fair Isaac’s website has an education section about credit scores and how to improve them, which is really useful, and a must-read.

Here are the components of your score:

• 35% payment history
• 30% amounts owed
• 15% length of credit history
• 10% new credit (lots of new accounts lowers your score)
• 10% types of credit used (not using multiple types lowers your score)

Seven Credit Score Truths

• Missed payments on even 1 card can cause increased interest rates on all of your cards
• “Installment” debt owed (e.g. mortgages, auto payments) does not reduce credit score
• Late mortgage or credit card payments and collection accounts (if paid up) can be removed from your credit report by calling the creditor (credit agencies cannot make these changes)
• Late payment history is removed from the credit report after 7 years
• In general, credit report inquiries drop your credit score - BUT, multiple queries within 30 days do not cause your score to drop (i.e. it’s not bad to shop around your mortgage)
• Paying off student loan doesn’t improve credit score if the loan is current
• Your highest credit balance (ever) is what matters, rather than max credit (your credit card limit)  e.g. a credit card with a 30k limit, but the most you ever charged in a month was 5k, if you charge 5k again in another month it is considered “maxed out” at that point, since you never had a higher balance.  The 30k means nothing.

Building Credit History (can’t get a credit card?)

Building credit can sometimes be a chicken-and-egg problem - you can’t get a credit card without credit history, but you can’t build credit history without a card!  One of the best ways to improve your credit score is to have a long history of always paying off your debt on time.  To start building your history, here’s some ways to get it going if you can’t otherwise get a card:

• Secured credit cards - you pay a certain balance up front, say $500, and then get a $500 limit.  Doesn’t sound all that great, but it is if you can’t get a card elsewhere.  Find one that will send your collateral back after a certain period of time.
• Local bank credit cards - often times local banks or credit unions are more willing to issue cards to ‘new’ chargers

Credit Score Optimization Strategies for Home Buyers

If your score is decent, little ups and downs caused by fluctuating credit card balances, new accounts, inquires, etc aren’t a big deal.  But if you are shopping for a mortgage, your current credit score is very important because it affects an interest rate which can in turn affect your finances for another 30 years or so.  You should do the following:

• Do not open or close accounts (including credit cards)
• Check your revolving accounts balance, keep it low
• Check your credit limits, and your highest balance (based on card history) - make sure cards (including Amex ‘charge cards’) have not been charged near their highest balance limits in the last 1-2 months
• Do not pay off accounts in collection

Remember that shopping around a mortgage doesn’t lower your score!

Fraud and ID Theft

Sometimes you can’t help it - wallets get stolen, cards get left a bars… most times you can just cancel the cards, kick yourself in the shin and get on with life.  But if there are unauthorized charges, here’s what to do:

• File a police report (very important)
• File an affidavit with the creditor
• Get the creditor to delete your name from the account (reporting agency can’t help here)

If you are worried about future stolen cards or your credit report in general, you can use a credit score monitoring service - it costs money, but can be worth it if your credit is fragile.  Check out myfico.com.  Personally, I just order a report from one of the 3 agencies every 4 months on a rolling basis so I always have a pretty up-to-date view of my report.

Any rumors you’ve heard about cards?  Stories about your credit?  Leave it in the comments!