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As I have mentioned, I primarily hang out on the MI Board. There I've become sort of the kindergarden teacher, helping those just starting out to understand mechanical investing.

I have also wrote a 180 page beginner's guide several years ago on the subject, which I am in the process of revising. Much of that guide covers subjects that a beginning investor should learn, no matter the style they end up using (like LTBH). Recently I posted the fourth chapter in the revision which covers "Investment Objectives".

Since there was talk of an "emergency fund" in another thread, I thought I'd repost what I wrote. Hopefully this will help those just starting out since nothing is more fundamental to good investing.


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.)

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".

"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:

"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."

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."

"Investing Beginners Board Note: For those of you reading this on the Investment Beginner's Board this section discusses the various methods of portfolio diversity. Since part of the discussion on this was covered in a previous lesson, I will remove this part for now, and repost them together in another post to this board.

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 mllion
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 “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:

4.9a 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.

4.9b 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.

4.9c Charlie's Investments.
Not much I can add to Charlie's investment objectives. We applaud his charitable intentions.

4.10 “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.


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.

For more help on budgeting check out, TMF's Budgeting Board. This post in particular is good for someone starting out

Also the "Living Below Your Means" Board
and in particular this series of posts by Papii (look at the bottom for Level

"Coupon N'More" Board FAQ

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