Remember, there is something called inflation. The price of things goes up every year. The average inflation rate for the past few decades is about 3-4% a year. In order to maintain the same quality of life, my investment needs to keeps up with inflation after taking $100K each year.

So, how exactly should I do it? Based on historical data, stock and bond returns 10-11% and 5-6% per year respectively over long term. If I were retired today and keep everything in bond, the net gain after inflation is only 1-2%. And therefore, I need to have at least $5-10 million in my bank, which is quite difficult to accumulate.

If I keep everything in stock, the net gain after inflation is about 7-8% and I need only $1.25-1.5 million to retire. That makes me feel better.

Of course, it is very risky to have an all-stock portfolio during retirement. To add some buffer, probably $2 million is a good goal to aim for.

Why do I say so? Well… there is one thing called “FICO” score. What the hell is it?

It is a credit score and FICO is the acronym for “Fair Isaac Corporation”, a publicly-traded corporation. ( )

FICO score is derived from a credit score model created by Fair Isaac Corporation and is widely used by banks and lenders. FICO scores are intended to show the likelihood that a borrower will default on a loan. They range from 300-850. The higher is better and therefore lower interest rates.

Just did a study on how FICO score affects my personal finance. According to MyFICO.com, for a 30 Year fixed mortgage with a loan amount of $300,000, here is the monthly payment

There is a $900 difference ($2676 vs $1779) on the monthly payment depends on the credit score. Over 30 years, a person with poor credit score pays $324000 more than the one with excellent credit score.

I have poor credit score… what should I do? According to WikiPedia , here is the approximate weighted contribution to FICO score:

35% - Punctuality of payment in the past: Tip: make payment on time.

30% - amount of debt: Tip: reduce your debt (e.g. credit card balance, student loan, etc)

15% - length of credit history: Tip: if you have too many new credit card or new debt, it is good to eliminate the new ones and keep your oldest credit card.

10% - type of credit used (e.g. installment, revolving, consumer finance)… not very clear how this is calculated

10% - recent search for credit and/or amount of credit obtained recently: Tip: when going to mall, don’t get a store credit card just to get some discount. It may cost you more when you want to apply for a mortgage.

Credit score reporting is handled by 3 agencies (Equifax, Experian, and TransUnion). Whenever your applied for a loan or delinquent on a payment, these agencies are notified. Banks, lenders and even landlords obtain your credit score from one of these agencies to help their decision on loans and leases. Sometimes, there maybe inaccuracies in your credit profile, it is a good idea to check your credit report or get automatic alerts ( )

So, you are responsible for your behavior. Be frugal. Live within your means.

hmmm… how does that happen?

Basically, it is a method for estimating the time it takes for an investment to double. For example,

if your investment appreciate 6% a year, it takes approximately 12 years to double in value. If it returns 9% a year, it doubles in about 8 years. You may see the relationship here…

Annual return * number of years = 72

Of course, it is just an approximation. However, it is simple enough to remember. Why is it important?

Well… if you want to be rich, you better keep this formula in mind when you are making any financial decisions. For example, if you have $10,000 to invest and you keep it in saving account and assume it yields 2 percent a year. And 36 years later, you find that it is worth $20,000 only.

On the other hand, if you put it in stock, mutual fund or ETF, over long time, it is possible that it yields 10-12% a year. According to the rule of 72, it doubles every 6 or 7 years. And 36 years later, you find that your investment becomes $320,000. It makes a huge difference.

Yeah… your may lose money in short term if you invest in stock, mutual or ETF. You may think that it is risky. However, if you investment horizon is long enough, these investment tends to give you positive return.

However, greed clouds people’s mind. They may take on too much risk and at the end lose every thing.

In my early years of investing, I don’t know how to control risk and lost quite a bit in stock market during Dot Com Bust.

The following video shows how someone bets small in the beginning. However, she doesn’t know that she is not a good player and keep on betting (more and more). She loses everything, including her clothes and became naked.

This applies to investing too. Know your strength. Know when to cut lost. If you don’t do that, you know the result and shame on you.

1. Price/Book ratio < 1.0
2. Return on equity > 10%
3. EPS growth for next 5 years > 10%
4. Debt to capital ratio < 25%
5. Market cap > 2 billion

Someone asked my how do I come up with these…

Price/Book ratio: this compares the stock price and the book value per share. If this ratio is below 1, the stock worth more than the price. We all want to get bargains, right?

Return on equity:This measure how effective and profitable the company is. If ROE is > 10%, for every dollar the company is worth, it generates at least 10 cents.

EPS growth: Some companies stock price drops because they don’t have bright future. When we search for stocks to buy, we better bet on companies with consistent growth.

Debt to capital ratio: Borrowing is a way for company to get the capital to grow. However, excessive borrowing could be problematic. High debt may be ok during good times, however, it could destroy a company during bad times. One recent example is American Home Mortgage. It was the biggest mortgage lender. However, when subprime mortgage crisis surfaces, they didn’t get the necessary financing and it has very large debt to capital ratio. It ultimately declared bankruptcy and caused severe loss for shareholders.

Market cap: I personally prefer established companies because they usually have longer history and more analyst covering. In addition, there are more buyers and sellers and their shares are more liquid.

These 5 tips gives us some stocks that have low price, effective management, good growth and are less likely be wiped out during down market. Of course, picking a winning stock requires much more these. One needs to take a closer look at their balance sheet and business to understand if it is really a ‘value stock’ or a ‘value trap’.

Here is how I ‘run my own *credit card company*’ and charge people for 11.5% on personal loans.

Good track record: Someone mentioned about Prosper.com to me last year. It is startup creating people-to-people lending marketplace. Chris Larsen is the co-founder and CEO of the company. Prior to Prosper.com, he founded E-Loan and served as chairman and CEO there. E-loan closed $27 billion in consumer loan and went IPO in 1999.

Revolutionary concept: Prosper.com is probably the first company embraces the online P2P lending concept. Basically it does match making between small lenders and borrowers. For example, borrower Joe wants to borrow money to buy a computer. He either needs to use a credit card or personal loan . Interest rate for credit card is usually high (even for people with good credit score). In case Joe tries to take a personal loan through a bank, he probably won’t be able to do it because bank usually requires collaterals.

Win-Win: Prosper.com offers the 3rd option to Joe. He could get a loan (without collaterals) through a group of small private lenders (could be you and me). Each of the potential lenders bid for the loan. Jack may offer Joe a $100 loan for the rate of 9% , Jane offers $200 for the rate of 10% and so on. The lenders who offer the lowest rate win. It is a good deal for Joe because he usually gets much better rate than credit card or personal loan. It is also good for private lenders because the rate is usually higher than CDs, money market or saving accounts.

Trust system: Initially, I thought that it is risky because how do I make sure stranger Joe pays the money back. The solution from Prosper is simple and elegant. It shows the credit score and credit history of the borrowers. People know about that if Joe has defaulted any loan before or is behind on payment. They also work with collection agents to make sure loan is promptly repaid. If he doesn’t pay, his credit score will be hurt and makes it more difficult for him to obtain loans in the future. It is pretty effective.

Diversify: In addition, the system enables lender making micro-loans (as little as $50 per loan). If I have $5000 to lend to people, I could lend it to 100 people ($50 each). If one of them defaulted the loan, my overall return is reduced by 1% only. I think it is safer than lending the whole $5000 to my brother.

My result: I have been using Prosper for almost a year and nobody defaulted on me. So far, the ROI is about 11.5%, which is pretty good. I am lending to about 80 people. 60% of them have AA credit rating, 20% with A rating, 10% B rating and 10% C rating. On average, I charge 8-9% interest rate for AA borrowers and about 17% for C borrowers.

Finding the right borrowers:

1. Don’t be greedy: although I could charge 25% or even higher interest rate by lending to people with credit rating D or below. However, I think that it is pretty risky because those are people who are likely to have financial difficulties.
2. history will repeat itself: if someone defaulted a loan before, he/she is likely to default again. Avoid them.
3. Low DTI ratio: DTI stands for “debt to income ratio”. The lower the DTI ratio, the more spare money the borrower has and more likely they will repay you.
4. Autopilot: I know that it could be additive to monitor the bids closely. However, I prefer to do it in a scientific way. Prosper has a feature called “standing order”. You could specify the criteria which borrowers should match (e.g. high credit rating, low DTI ratio, etc) and Prospers places the bid for you should there be a ‘qualified’ borrower. It is a pretty good feature and I could sit back, relax and my money grows

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The following is a screenshot from my ’statcounter.com’ account

1. Price/Book ratio < 1.0
2. Return on equity > 10%
3. EPS growth for next 5 years > 10%
4. Debt to capital ratio < 25%
5. Market cap > 2 billion

Five companies shows up…

1. Aspen Insurance Holdings Ltd. (Symbol : AHL)
2. Allied World Assurance Holdings Ltd. (AWH)
3. Armstrong World Industries, Inc. (AWI)
4. iShares MSCI EAFE Index (EFA)
5. Endurance Specialty Holdings Ltd. (ENH)

3 out of 5 are in financial industry. The 2 exceptions, Armstrong World Industries is in the construction industry while EFA is a ETF (Exchange Traded Fund) investing heavily in financial and construction industries in foreign countries. Looks like the sub-prime crisis really hurts these 2 industries. In any case, I will have to analyze them further before my next move in my (virtual) portfolio.

Currently, my portfolio includes 2 long positions (Symbol: GOOG and CDS) and one short position (Symbol: SPY). It is far from being a comprehensive portfolio. My goal is to hold about 20-30 stocks/ETFs eventually. The market is very volatile for the past few months. The sub-prime crisis and the fear of recession will probably drag the market down. That’s why I am shorting SPY at the moment. At the same time, I am looking for companies that have strong balance sheet and low valuation. When the market is over-sold, I will buy some stocks.