Motley Fool Mechanical Investing Board - Part IV

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Lesson 4: Mechanical Investing Boot Camp

4.0 Introduction Like many young men, I joined the US Army at 19. It was 1976 and Vietnam was recent history for America. In Basic Training, my Drill Sergeant had a favorite saying, which he loved to call "The Seven Ps."

Prior Proper Planning Prevents Piss Poor Performance!

That simple saying has stuck with me through my life and into my investing. Anytime you start something new, often the best way to begin is with a little planning. Most people jump right in, but taking a few minutes to plan, will save you hours of headaches later.

4.1 Investment Objectives. First, turn the Infernal One Eyed Monster off...

Yes, I know turning your computer off is hard. Maybe just let it sleep for a while without you. Trust the Doctor, it's in your best interest. (Now, stop your whimpering) Take a notepad and go sit under the trees for a while. Find a park with kids playing and dogs chasing Frisbees. Raining? Put your feet up, slide a good CD into the drive, and relax. Time for you to do some thinking.

Ask yourself, "Where do I want to be with my life in 12 years?"

Many times when discussing financial planning, the author has you making plans 20, even 30 years into the future. I prefer looking a little closer. 12 years is far enough for some dreaming, yet close enough to be affected by what you do today. So sitting under that tree, do some dreaming. Unless you plan on joining a religious order and retreating from the worries of the world, (and that order taking care of your financial needs), where you see yourself in twelve years provides you with a goal around which to plan your future investing. Also consider any short-term goals. Do you have an older car, which you may want to replace in a couple of years? Thinking of a second honeymoon next year?

What was on the top of your list? Did you say retired and enjoying your life? That's not surprising. In a poll on the MI Board 83% of the people responding said they invest to "Provide for a better retirement."

(12% had no particular objective to their investing besides making money, and 4% invested for future big-ticket items including their children's education.)

At our first Mechanical Investing Convention MICon held in Las Vegas April 2000, Ken Meyers (FoolishlyFree) give us some sobering statistic:

Out of every 100 people reaching age 65.

• 33 will have died before reaching 65
• 57 will be broke
• 9 will have enough income to "get by"
• 1 will be wealthy

And more chilling in my mind, out of every 100 people receiving Social Security.

• 45 depend on relative to help make ends meet
• 30 depend on charity to make ends meet
• 23 are still working
• 2 are self sustaining

(A note from Ken: The tables came out of a book titled "The Best Kept Secret in America". It cited a study done by the Social Security Administration c1997. Please keep in mind, that if someone had earned income greater than a certain amount, they would not be receiving Social Security.)

Looking at these numbers is there any reason you can think of for not getting your financial house in order now and begin investing. Or is Alpo that tasty?

4.2 Budget Buzzcuts. In the movies you always see the group of new recruits marching down to the base barber. Buzz, buzz, buzz, out they come, hair cut short. As a new investor, you might want to go through a similar symbolic haircut of your own, "Creating a Budget".

How much did you spend on fast food last month? You might be surprised. IMO if you haven't taken the time to review your expenditure and make a budget you should. At the very least take a month and track your money. See where you spend it. You'll be surprised and maybe you can trim 10% from somewhere. That 10% added to the money you invest will quickly add up.

Trimming a mere $50 a month ($600 a year) and adding it to your investing, at 20% annually, that $600 will grow into $5350 in 12 years. Isn't compound interest great!

(If you don't understand what I meant by "tracking your money", this is a fairly painless way to see where you spend your money. Pick up an accountant style journal from the stationary store, and for one month, write down every expense you have. Gas, groceries, donuts and coffee in the morning (with 25 cents for a paper), bills, etc. Write down every expense. Be sure not to try and be frugal. You want an accurate picture of where your money goes. Then at the end of the month, add everything up, putting the various expenses into some general categories. Housing, Auto, Food, Debt Payment, Savings, Entertainment. You want to see the general trends in your spending. It will simply amaze you to learn what you spend your money on. It did me. Once you know where you spend money, then you can start cutting back.)

(Check FURTHER READING at the end of this lesson for more resources to help you budget.)

4.3 A Wiser Recruit. Having had a year of ROTC in college before I joined the Army, I had a pretty good idea of what awaited me. I did myself the favor of getting that haircut before going in. So let's say you too, are a little wiser as an investor, and have a budget in place. Back to that notebook and the park.

Write in big letters across the first page of that notepad the investment goal you've come up with; probably "Retirement." Under that put any short-term (3-5 year) goals you have. Now draw a line down the center of the page. To the left write "Assets", to the right "Liabilities."

Again with a nod to Ken, here is a quick definition. Assets are money or anything that makes you money. A Liability is debt or anything that costs you money. Pretty simple.

So under Assets write down things like Paychecks, Bank Balances, CDs, Money Markets, Company Retirement Plans (401s & 403s), IRAs, Stocks, Bonds and anything else that is money or can be easily liquidated. (I know IRAs can't be touched till 59 1/2, but they are Assets you'll draw then.) That big screen television you bought for the Super Bowl doesn't count, but if you have a small treasure chest of gold bars hidden under your bed add that.

Under Liabilities write down things like Credit Card Balances, Outstanding Loans, Alimony or any other reoccurring debt. Don't be too concerned about being accurate to the pennies, you just want a general overview of your finances.

Now your home if you own and your car are not assets. People will argue with me about that, but losing either will seriously affect your life style, so you can't reasonably go out and sell them. And both have reoccurring out of pocket expenses. Rental property might be an Asset, as long as your cash flow is positive. That old roadster in the garage that you're restoring is not an Asset, it's a Hobby. :)

Ideally in 12 years when you retire, you'll want little or no outstanding Liabilities, just lots and lots of Assets. Making lots and lots of money!

4.4 Mongo like machine gun!" One of the secrets of putting together squad of soldiers is to first gain an understanding of each of their strengths and weaknesses. Then use each person in their best capacity. A small wiry man might make a great point, slipping through the jungle and scouting out the trail. He would not be the best choice to carry the squad's machine gun. That task is much better left for that beefcake who bench presses 200 lbs for fun. The same goes for your investments. You want each asset working in the area of your financial squad to its best capacity.

Time for a Workshop article by Todd Beaird (TMFSynchronicity), entitled "Foolish Portfolio Allocation". http://www.fool.com/Workshop/1999/Workshop991109.htm

"A question that often comes up in the Workshop, especially when the market gets volatile, is: "How much of my portfolio should be in stocks?" The answer, of course, depends on your life and your risk tolerance, but there are some rough guidelines you can use.

First of all, as mentioned in Step 2 of the "13 Steps to Investing Foolishly", you should pay off all high-interest debt and develop the habit of saving a little (or a lot!) from each paycheck before you even start thinking about stocks. Once that's done, it's time to start thinking about where to put that savings. Generally, your investments can go into one of three "buckets."

Bucket A is an emergency fund, which is cash set aside in a money market account or similar safe, instantly accessible place for... well, for an emergency (you lose your job, your septic tank explodes, statisticians hurl grapefruit through your front window, etc.).

Bucket B represents savings that you will need within the next three to five years for extraordinary, but foreseeable, expenses. For example, saving for a down payment on a home, kids going to college, your next car, that mountain chalet, etc.

Bucket C is long-term savings (money you won't need for at least three years, preferably much longer). Historically, the best place to put money long-term has been the U.S. stock market. You don't have to put all your Bucket C money in the market, but not doing so is likely to cost you money down the road.

The amounts you have in each "bucket" will change as your life changes. If you're fresh out of school, your emergency fund may consist of a case of instant ramen noodles, canned goods (soup, tuna, and -- my personal favorite -- cold, canned pasta), and the possibility of moving back in with Mom and Dad. After you get married and have kids, your emergency fund will probably consist of cash to cover anywhere from one to six months of expenses, depending on how stable your career is. With kids, many people will enlarge Bucket B in preparation for college.

As you approach retirement, you should shift some of your long-term savings into the A and B buckets to cover expenses after you stop working. Just remember that with any luck, you'll live for a number of years after retiring.

Also remember that 401(k)s and IRAs offer an excellent opportunity to save Bucket C money tax-deferred (or tax-free in a Roth IRA). As we've discussed the last few weeks, taxes are a huge drag on investment returns. If Uncle Sam offers an opportunity to save tax-free, just say yes! And if your employer matches 401(k) contributions, even better. Can you say "free money"?

Now, what was missing from the above? That's right, NOWHERE did we mention current performance of the market! Foolish investors don't care how current P/Es compare to historical numbers, or whether the Fed will raise interest rates. Nor do we have any magic formulas of 60% stocks/35% bonds/5% cash or other nonsense. Foolish investors don't let the market run their lives, they make sure that their lives are running their investments!

Once you start looking at your investments this way, it gets easier to think long term and weather the ups and downs of the market. Rather than saying, "The market's down, what should I do with my portfolio," you'll say, "Looks like we'll be needing a new car in a year or two, what should I do?"

Here in the Workshop, we're looking at ways to invest Bucket C money -- and ONLY Bucket C money -- through mechanical stock screens. We can't guarantee that we'll beat the market, but we're trying to be disciplined and rational in testing our methods and quantifying our results."

Then Moe Chernick, in a follow-up Workshop article "Do You Really Need Three Buckets?" made a good point: http://www.fool.com/Workshop/1999/Workshop991123.htm

"Bucket B should represent money that you can't afford to lose in the next three to five years."

If you Bucket B money is already on hand, and it is important that you meet the intended obligation, a child's college tuition is a good example, then investing it in the market, places too great a risk on losing the funds. What you can do though, for goals that have a flexible time frame, is exchange the risk of the market taking longer to give you your needed returns, for the chance the market will give you your needed returns faster than you expect.

(Lose you there?)

Take the example of buying a house. If you can accept the risk that your investments may under perform, meaning instead of three years, it may take five, then it frees you to take a higher risk in your choice of investments. And in doing that, should the market over perform like it did in 1997-1999, then you might find you could afford a house sooner than planned.

Back to the shade of that tree and our investment objectives. Put that first page of your notepad to the side. On a fresh piece of paper write the following,

- Bucket A: Emergency Funds - Bucket B: 3 to 5 year Goals - Bucket C: Long Term Goals

then below that,

- Secured/Low Risk: Insured or Guaranteed Investments - Medium Risk: Broad Index or Mutual Funds, Standard Screens returning <30% - High Risk: Sector Funds, Individual Stocks, Screens returning 30-70% - Very High Risk/ Speculation: Options or Bullets Screens returning >70%

Some people will argue about how I divided the risk. That's fine. Risk is a personal thing. If 70% seems too high or too low, then change the percentages. They are, after all, your investments.

Take the first list and begin by placing each asset into its appropriate bucket. Then within each bucket, place it in the Risk Category you think it belongs.

4.5 Our First Recruit. Adam is the manager of a successful national fast food restaurant. His position is fairly secure, and he may be promoted to city-wide manager next year. He is 34 years old, single with no children, though he is seeing someone. They have no marriage plans, but Adam has hopes.

His Assets are, - $950 a week in Paycheck - $3000 in a Savings Account - $11,000 in 1yr CDs headed towards a new car. - $22,000 in company 401K invested in an index fund. - $40,000 in a taxable broker account. - $40,000 in a Roth IRA invested in 18 emotional stocks.

(During 1998 and 1999 Adam was heavy into tech stocks and did well. Then gave half of his gains back during 2000 and 2001.)

He has paid down his credit cards to $850, which he plans to pay off by year's end. Other than that he has no debts. Adam spends about $2100 a month covering all his expenses. He figures he can meet his IRA contribution, and add another $2K a year to his taxable account if careful.

For Adam's long-term goal, he would like to have three million dollars in IRA/401K Assets at 55, and another million in his taxable account. He could then consider retiring early, first on the taxable money, then on the IRA at 59 1/2. His short-term objective is to buy a better car in 2-3 years, and might use some of the taxable account for that.

So Adam breaks his investments down like this, 1. Bucket A-Emergency Fund Secured/Low Risk: $3K in savings 2. Bucket B-3 to 5 year Short Term Goals (auto) Secured/Low Risk: $11K in CDs 3. Bucket C-Long Term Goals (retirement) Medium Risk: $10K in taxable Medium Risk: $22K in 401K/Index Fund High Risk: $80K in Roth IRA/Stocks

Pretty simple. This is all you really have to do as an "Investment Objective." With that you can evaluate what changes you want to make, and how mechanical investing can fit into those objectives.

(We'll get to those changes later in this part.)

4.6 "You can juggle hand grenades, just don't pull the pins first!" I mentioned this in the last lesson, but it bears repeating.

"Most hobbyist traders assume that the name of the game is price prediction. (finding those stock which go up) But it's not. The name of the game is risk management. The first goal is to ensure survival. You need to avoid risks that can put you out of the game. The second goal is to earn a steady rate of return, and the third goal is to earn high returns � but survival comes first." arezi

Looking at the above example I can hear people saying "Index Fund, medium risk? And stocks are high risk?" After the way the market has performed the last few years, does anyone not think the market has its share of risk? A lot of people found out they were more sensitive to risk than they thought, especially after watching their portfolio drop from a gain of 90% to a loss of 30%. Hurt didn't it?

Now I would love to give you a simple clear-cut method of evaluating risk and a plan to manage it. But the fact is risk and how we deal with it is something each person handles differently. The only thing I can say is every time you experience large swings in your portfolio, the easier it seems to become to tolerate. Kind of like sheep farming.

(You'll understand that reference in a few lessons.)

So the important thing is not to take on too much risk to start. Build up you tolerance. Two methods I have found that work for me are diversity and limiting your exposure to high risk.

4.7 "Teamwork is essential, it gives the enemy someone else to shoot at." We talked a bit about diversity, specifically diversifying across stock types in Lesson 3. Let's talk about some other types of diversity.

4.7a Numerical Diversity. In early 2000 if you play with the backtesters long enough you come to the conclusion that holding just one or two "cherries" is the road to riches. PEG26 Quarterly #2 is a good example. For 1996 through 1999 it returned 190%. 843% in 99 alone! But had you done that in early 2000, you would have lost big. Limiting yourself to just a couple of stocks is one of the quickest ways to lose it all.

Michael Meyer (Mrmeyer) sums it up pretty well. "The math should not be a substitute for common sense. Companies cannot be reduced to a simple equation. If you have a formula that chooses a single company with excellent backtested returns, all that shows is that the shark infested waters were navigated successfully, but due to luck, not skill. Your formula will not protect you against:

- The company restating past earnings. Oops, bookkeeping practices were disallowed by the SEC. -Natural disasters. Oops, an earthquake in Taiwan. - Outright fraud. Oops, the company president ran off with the secretary and took the company checkbook. - Sudden government policy changes. Oops, gene mapping information will be free to everybody. - Patent concerns. Oops, your competitor's machine doesn't infringe upon your patent after all. - The formula (MI screen) wasn't foolproof after all, and an unqualified company becomes your selection.

The list can go on and on, all stumbling blocks are not seen. MI screens, selecting a group of stocks, add necessary diversity to protect against a single company bringing down the entire portfolio."

So how many stocks should you have in a portfolio? Let's run through a simple example to illustrate the effect of diversity.

4.7b An Example on Diversity. For our example, we will assume that with each selection we have a 60% chance of buying a stock that doubles and a 40% chance of buying a stock that drops 50%.

Our long term average return will be the percentage of gain (60%) times the expected return (2.0) plus the percentage of gain (40%) times the expected return (loss of 50%). In this case, a zero return would be equal to 1.0, so a 100% return is 2.0, a loss is 0.5

0.60 x 2.0 + 0.40 x 0.5 = 1.2 + 0.2 = 1.4 or 40%

As we would expect. So if we pick 1 stock we have: 40% chance of losing 50% and 60% chance of winning 100%.

If we pick 2 stocks we have: 16% chance of losing 50% (2 losers) 48% chance of winning 25% (1 winner, 1 loser) 36% chance of winning 100% (2 winners).

If we pick 3 stocks we have: 6.4% chance of losing 50% (3 losers) 28.8% chance of breaking even (2 losers, 1 winner) 43.2% chance of winning 50% (2 winners, 1 loser) 21.6% chance of winning 100% (3 winners).

How are we getting these numbers? If we pick 4 stocks, to find the chance of 3 being losers and 1 being a winner, we get the probability by 0.60 x 0.40 x 0.40 x 0.40 = 0.384 but because when we have 4 stocks, this situation could happen 4 times. Win Lose Lose LoseLose Win Lose LoseLose Lose Win LoseLose Lose Lose Win

We have to multiply 0.384 by four or 15.4%. The expected return in this situation would be 2.0 + 0.5 + 0.5 + 0.5 = 3.5/4 or 0.875. Subtract this from 1, and the expected return is a loss of 12.5%

So if we pick 4 stocks we have: 2.6% chance of losing 50% (4 losers) 15.4% chance of losing 12.5 (3 losers, 1 winner) 34.6% chance of winning 25% (2 losers, 2 winners) 51.8% chance of winning 62.5% (1 loser, 3 winners) 13% chance of winning 100% (4 winners)

And finally if we pick 5 stocks, the chance of all 5 being losers is 1 percent.

One thing you'll notice is that the chance of losing 50% will never drop to zero, but it becomes small pretty fast. The other thing is that the chance of a 100% gain also drops, but not as fast because our example assigns a better chance to winning than to losing. As the number of stock picks increases, our overall result tends towards the long-term average return of 40%.

How does this affect a blend of several 3-stock screens? The answer depends on the probability distribution of each screen, and this is all a very artificial example. If all the screens in the blend behave the same, then buying 3 stocks from each of three screens is the same as buying 9 stocks from a single screen. The diversification is pretty broad, and the chance of running into a very bad loss randomly is very small.

Shifting market conditions could slide real win-loss ratios in extreme directions for any screen. In this model, rounded constants are used so that the math is digestible, and extreme (but possible) gains and losses are used to make the differences easily apparent.

(Thanks to Geocorona, TMFElan, William Lipp and Steve Power for the math behind the example: http://boards.fool.com/Message.asp?id=1030063002420000)

4.7c Diversity Within a Screen & Diversity Across Screens. Additionally when dealing with portfolio allocation and risk management, you will see discussions of diversity within a screen (picking 1-10, instead of 1-5) and across screens (picking 1-5 in two screens).

As you saw in the example, once you get to 5 stocks deep in a screen the probability of picking all losers is about 1%. Remember, that's "all stocks", not some. You can expect to have at least a few losing stocks whenever you use a screen.

A blend of three screens of #1-3 would have the same GSD of a screen holding #1-9, probably low, but the CAGR would be higher because it was a combination of three CAGRs of the #1-3 stocks. So it's better to go 5 stocks across two screens than 10 stocks deep in one. But only if the screens you use don't pick the same type of stocks. You would not expect that a blend of RS13, RS26 & RS52 week screens would have much diversity. This is why we diversified across the various stock types with our mock portfolio.

It pays to make sure the screens you use, pick from different areas. Also sometimes screens will intersect. A Quick and Easy way to see how different two screens are is to run Jamie Gritton's Overlap backtester for the last 2 years, 1998 & 99, as a monthly. Two years will show you any near term trends. Note how much overlap between the screens there is. Go 10 deep, picking 10 stocks. This will show you how many stocks are held in common by both screens. Screens that pick many of the same stocks will not give you diversity. Look for screens that pick different stocks in the same time period.

(We'll learn more tricks that you can do with the backtester in the later lessons specifically on the Backtester and Screen Builder.)

So how many stocks do we need to use in each screen? No more than 4-5 deep looks to be sufficient. But how many total do we need?

Many value investors will tell you that more than 6-8 stocks are over diversified. "Diversity is the crutch for poor due diligence" is an often quoted line. The implications is those who hold more have not taken the time they should have to properly research their holdings. While there may be some truth to that in fundamental investing, when doing mechanical investing you are targeting groups of stocks. So you expect some stocks to do poorly while most will do well.

"When it comes to MI stocks, I believe the only reason you should set a max on the number of stocks is to keep the commissions low. In other words, if you are paying no commission or very low commission compared to your investments I wouldn't worry at all about how many MI stocks you own. Emotional stocks are another story. With emotional stocks I think setting a limit is a good idea because it helps you focus on buying only your best ideas and once you have a portfolio it means you have to sell something if you want to buy something else. IMO as a general rule 8-12 sound fine but you may want to set your own limit differently based on how much money you are investing and how many stocks you can really follow and understand at one time.

In either case don't count your MI stocks against your limit or worry about owning too many of them. And the next time someone tells you that a limit is a must remind them that Peter Lynch killed the market for years while owning 100s of stocks." Moe Chernick

So your limiting factors are Cost and Time. Don't buy more MI stocks than you can afford to keep costs like commissions and spread below the recommended amount of 90% of CAGR. Don't buy so many stocks you have difficulty managing your portfolio. Most people find that a portfolio of 12-18 stocks works well.

4.7d Time Diversity You will see the term "Diversified Across Time" mentioned. The thought being that by going to more frequent trading, re: monthly or quarterly, that the screen is rotating you out of losers quicker.

"I must say I don't buy the arguments I've seen (so far) for "diversity in time." That is like saying you have less chance of being in an accident during a cross-town taxi trip if you (and your family) change cabs every 10 minutes. Your exposure to unanticipated market risk or company risk is the same whether you trade weekly or yearly. While frequent trading may have higher returns for certain screens, you can't attribute that to "time diversification". It is simply that you are invested based on fresher data." JimDS

So for true diversity, you would want to spread your family (portfolio) to several taxis. This way if any one taxi were in an accident the chance of all your family being injured is reduced. You will not get diversity if you use just one screen, no matter how often you rebalance. Use several screens, that way it would take a broad market downturn to affect all your stocks. Just like we saw in early April 2000. It is interesting to note, during late 1999, many people were considering dropping their value portion of their MI portfolio. What went up during early April while the NASDAQ was getting massacred? Value stocks.

If a complete drop in any one of your stocks can lose you more than 10% of your portfolio, you are probably not diversified enough.

4.7e When to Accept Less Diversity. New investors just starting out, and those people starting late in life, sometimes have to choose. They can accept lower returns with some diversity (Index funds) or they can choose to accept a bit more risk, sacrifice diversity for increased returns. If you know you will be adding funds often, say every quarter or month, you may decide to accept less diversity starting out. By adding funds you are decreasing any loss, in a purely bookkeeping manner.

A simple example: If you start a 4 screen quarterly with $40K, $10K a stock, and experience a complete loss in one stock, you lose 25% of your investment. If you do the same, but add another $10 every quarter, your total investment for the year would be $80K. A first month's single stock complete loss would only be 12.5%. By adding extra money, you've cut your risk in half. Accepting less diversity is one case where you need to seriously weigh your options. No one can make the decision for you.

Author's Note: Rensor1 posted his real life experience with MI, turning $272K into over a million dollars by investing in just 5 stock, and at times as few as 3! He made the decision to sacrifice diversity to seek maximum gains. Very gutsy! By just about anyone's definition. It is well worth reading the original thread as well as the following several weeks of posts concerning his decision. A lot of good discussion on the pros and cons of limited diversity. http://boards.fool.com/Message.asp?id=1030063002406000

4.8 Two more volunteers soldiers. Let's look at two more examples.

4.8a The recruit. Betsy is a stuntwoman. Her business card reads, "The Second Craziest Woman In Hollywood". She is 27, and like Adam also single. Last year she made $125K in earnings. Betsy bought her 2003 Jeep with cash. She has $35K in a "rainy day what if" fund, currently in a savings account. While she has a great comprehensive medical policy from her union, if she gets injured she figures she'll still have bills.

A job accident last year laid her up for three months. This got her interested in her future. While recuperating, she took some computer classes and has found she has a "knack" for programming and web site design. This last year between jobs, Betsy has taken more classes. Last month she did her first paid web site.

Betsy has $15K in several blue chip stocks from her grandmother's estate. She has another $20K she'd like to invest in a CD maturing this month, and figures on being able to add another $50K this year in periodical additions. Her long-term goal is to retire from stunt work by age 30. She'd like to have a million in assets by then. She plans to continue with her schooling in computers, and hopes to pursue a career in Web design while she does stunt work. Then upon exiting stunt work, she'd like to open her own company. In the meantime, Betsy would like growth, but some security. She thinks she can handle the risk of an aggressive investing strategy, but worries about loss. She has no short-term goals at this time.

So Betsy breaks her investments down like this, 1. Bucket A-Emergency Fund Secured/Low Risk: $35K in savings 2. Bucket B-3 to 5 year Short-Term Goals: none 3. Bucket C-Long Term Goals-Asset appreciation: Low Risk: $20K in CD Medium Risk: $15K in blue chips

4.8b The Short Timer. Charlie is currently retired and a recent widower. An experienced investor he has $2.5M in assets, most in income producers and secured instruments. He also has his home paid off, and several rental properties which generate income. His wife's death left him with a $100K insurance policy that he would like to leave to charity. Charlie would like to see just how large of a bequeath he can leave in his wife's name. He is unconcerned about risk, since if he blows the whole thing it will not affect his personal finances. He will though, sell the entire portfolio if it drops below $25K and then donate the resulting cash from the sale.

Charlie breaks his investments down as, Bucket A: $2.5 million Bucket B: none Bucket C: Very Risky: $100K in taxable account.

More about our squad of three at the end of the Chapter, for now we'll look at some other concepts.

4.9 "If you can shoot at the enemy, the enemy can shoot at you." The second way to manage risk is to "Limiting Your Exposure to High Risk".

There was an anti-smoking ad running here in California, where three young people bungee jump from a bridge. At the bottom of the jump, they pluck a soda can from the rocks. On the way up, they open the can and drink. The first two have no problem. The third jumper has the soda can explode, blowing him up. The ad asks, "How many products do you know which kill one out of three?"

I use this commercial not as an anti-smoking message, but to ask, "How many of you would invest if one out of every three stocks you bought, lost all the money you put in them?" Scary thought!

If you spend any amount of time reading the MI Board, you will see posts on "6/3 Options". There's been a lot of money made with options, and while using Sparfarkle's 6/3 method helps increase the odds of winners, options are still very risky. Over and over, you will see us recommend you not have more than 10% of your total portfolio in options. Why? It is not unusual for 6/3 options to lose completely in a quarter, and sometimes even two quarters in a row. Keeping less than 10% of your portfolio in a high-risk strategy is a simple method of risk management. The less you put into a risky strategy, the less you can lose.

Sounds simple. And it is, but invariably when an investor is hitting great returns, they will focus just on those returns, not the risk of losing them. By limiting the amount a -2 or even a -3 sigma loss will impact you, will keep you in the game.

Something else. People will often focus on Blends and SOS's with very low downside volatility thinking they are safe from risk. To quote from the Master again, "Consider: the chance that your house will burn down is extremely small. Do you therefore cancel your fire insurance? No, of course not. No reasonable person would, even thought the odds are overwhelmingly in your favor. Why? Because if you get unlucky and have a fire you are wiped out. One of the psychological mistakes that people make is to treat very low probability events as having ZERO probability. A low probability of wipeout is not the same thing as a zero probability." Rayvt

4.10 The Dreaded M word, Margin. Nothing for the beginning investor will expose you to more risk of losing it all than Margin. Like a tiny devil on your shoulder, Margin will seductively whisper in your ear. "I'm only 7%. Look, the screens are returning 25%, use a little margin and you'll make more money!"

The way margin works is pretty straightforward. Margin is essentially a line of credit from your broker with your stocks as collateral. Like credit cards, margin accounts impose no repayment schedule. They are happy to keep charging you interest. You are free to repay the loan at will.

You draw on the credit to buy stocks and your broker then charges you interest. Borrowing money to buy more stocks enlarges your exposure relative to the value of your account. This works for you when the screens are winning, but in a down turn the losses will mount faster than had you only used your own cash.

The Federal Reserve Board sets the amount of margin brokers may lend to their customers. At present, the limit is 50% of the amount of your marginable stocks. Who sets which stocks are marginable? Each broker house does. And they can change their minds at anytime. Many people received unexpected margin calls right in the middle of the recent downturn.

A margin call is a demand by your broker to put up more collateral, either cash or other stocks, usually in 3 days. This can be a problem for many, as they rush to send in checks by overnight mail. If you fail to satisfy the margin call, the broker will sell the stocks in your account to collect the amount due. This penalizes you by not only selling your stocks at the time they are worth the least, but depletes your capital by locking in your losses. When the market comes back, and it always does, you end up having to repurchase the stocks you want at a higher price. Downturns are like roller coasters, if you get off at the bottom of the hill, you'll never see the view at the top.

Investors must never let themselves get into the situation of receiving a margin call. A broker will usually notify you ahead of time that your account equity is dropping. You should take steps before the call threshold to lower your exposure. We like to tell you to buy your screen stocks, and then don't look at them again until rebalancing. If you use margin, you need to keep a good watch on your account. You might not get that email notification and find your stocks sold, just at the worst time. At the bottom!

FAQ: "Why would a mechanical investor use margin?" One safe way to use margin is when you rebalance. Rather than buy rounding down, so as not to go over your available cash, you can round up to the next stock, and then simply send a check into your broker after your rebalance. Be careful that you do send in the money. (You can't buy on margin in an IRA.)

MI by its nature has you fully invested at all times. Some investors practice "Reverse Scale", which is an advanced investing technique that has you buying more of a winning stock at a preset threshold, usually at a 50% gain. Basically adding to your winners. Good when they are winning, bad when they drop.

(Reverse Scale Investing has is own board where you can find out more. http://boards.fool.com/Message.asp?id=1380714000002000)

Ben Goldman took the time to outline the math you need to know about margin, in order to assess how it fits into your personal level of risk. If you are thinking of using margin be sure to study Ben's excellent Primer. http://boards.fool.com/Message.asp?id=1030013010214000

4.11 "A Purple Heart just proves that you were smart enough to think of a plan, stupid enough to try it, and lucky enough to survive." So let's get back to Adam and his two fellow soldiers:

4.11a Adam's Investments. 1. Bucket A-Emergency Fund Secured/Low Risk: $3K in savings 2. Bucket B-3 to 5 year Short Term Goals (auto) Secured/Low Risk: $11K in CDs 3. Bucket C-Long Term Goals (retirement) Medium Risk: $20K in 401K/Index Fund High Risk: $80K in Roth IRA

Recommendations & Advice: (& 55 cents gets you a newspaper here.) 1. Adam's Emergency Fund is low, only about 1 1/2 months worth of expenses. He should probably increase that. By how much? 2-3 months of expenses is usually good when you have a secure and steady job. This he can accomplish over time, gradually increasing the amount each month.

In this situation, Adam has a $5000 line on his credit card. While buying things on credit is unFoolish, as long as he pays off any emergency expenses (auto repairs, etc.) within a few months he might be OK using his credit card as a backup until he gets more money in his Emergency Fund.

2. Short Term Goal- New Car. By being flexible with how quickly he wants to buy it, Adam has the option to move some, or all of his $11K in CDs into the market and seeking better returns than he'll get with the CDs.

3. While Adam might get more flexibility if he put his 401K into self directed stocks, most plans limit your choices. It's hard to argue with sticking to an Index Fund. And he might consider the same thing fr his taxable account, at least until he gets more money in it.

4. His Roth is well suited for a conservative MI portfolio.

4.11b Betsy's Investments. 1. Bucket A-Emergency Fund Secured/Low Risk: $35K in savings 2. Bucket B-3 to 5 year Short-Term Goals: none 3. Bucket C-Long Term Goals-Asset appreciation: Low Risk: $20K in CD Medium Risk: $15K in blue chips

Advice and $5 buys you de-caf. 1. Betsy's Emergency Fund while high by our standards is specifically gear to her situation. The only recommendation is to look for a better rate than a bank savings account. Many brokers offer better rates and "almost as quick" access in an emergency. So too with online banks. She should also look into a rotating CD, where she would place $2K a month into 1 year CDs. This would give here good returns and access.

2. The $15K in blue chip stocks can provide a value component to Betsy's investments, especially if she follows her plan to aggressively invest for growth. I'd say leave them be, though set up 3 month re-evaulations on all. If one lags, sell it.

3. The $20K will give her the beginnings of a portfolio, especially if she puts the additional $50K in this year.

4.11c Charlie's Investments. Not much I can add to Charlie's investment objectives. We applaud his charitable intentions.

BIG Author's Note:These three example people were first presented in the first edition of my "Beginner's Guide to Mechanical Investing". I made portfolio and screen suggestions then which I have since rethought, given both the recent market downturn and continuing research on the MI Board.

In Lesson 5 we will look over those suggestions and review the performance of the screens I chose through 2000 to present.

4.12 "There is nothing more satisfying than having someone take a shot at you and miss." Except when the market panics and you don't. Practice good risk management with all your investments, especially your MI investments. And finally a little something off topic, but perhaps pertinent with all this talk of Risk. You decide:

"The following is the transcript of an actual radio conversation released by the Chief of Naval Operations, of a US naval ship with Canadian authorities off the coast of Newfoundland in Oct. 1995.

Americans: Please divert your course 15 degrees to the North to avoid a collision.

Canadians: Recommend you divert YOUR course 15 degrees to the South to avoid a collision.

Americans: This is the captain of a US Naval vessel. I say again, divert YOUR course.

Canadians: No. I say again, you divert YOUR course.

Americans: THIS IS THE AIRCRAFT CARRIER US ENTERPRISE. WE ARE A WARSHIP OF THE US NAVY. DIVERT YOUR COURSE NOW!

Canadians: This is a lighthouse, your call.

Author's Note: Untrue, a naval legend that has been circulating for many years, but a good example of trying to go against something best avoided.

4.13 Lesson 4 Quiz

FURTHER READING: For more help on budgeting check out, TMF's Budgeting Board. This post in particular is good for someone starting out http://boards.fool.com/Message.asp?id=1040023000293000&sort=id

Also the "Living Below Your Means" Board http://boards.fool.com/Message.asp?id=1040018005174000&sort=id and in particular this series of posts by Papii (look at the bottom for Level 1-4) http://boards.fool.com/Message.asp?id=1040018004754000&sort=id

"Coupon N'More" Board FAQ http://boards.fool.com/Message.asp?id=1380738000038000&sort=id