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MI Boot Camp. Some Basic Planning Before We Start.
Doc's Unofficial Guide for New Mechanical Investors, Part 4.1

(If you haven't read Part 1, 2, & 3, please do. You can find them at

First, a bit of humor. Murphy's Law for the Military

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. Hopefully you won't have to go back and redo something.

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 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 recent poll 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.)

If you were lucky enough to attend MICon in Las Vegas April, then you heard 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

(The tables came out of a book call The Best Kept Secret in America. It cited a study done by the Social Security Administration c1997, IIRC. 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?

(Shameless Plug: If you didn't attend MICon, the annual Mechanical Investing Convention you missed out on one great get-together. You can get more info about it on the MICon Board at
and check out the handouts from the convention, especially FoolishlyFree's )

Budget Buzz Cuts
In the movies you always see the group of new recruits marched 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 on what you spend your money on. It did me. Once you know where you spend money, then you can start cutting back.)

For more help check out,
Budgeting Board, this post in particular is good for someone starting out
Living Below Your Means Board
and in particular this series of posts by Papii (look at the bottom for Level 1-4)
Coupon N'More Board FAQ

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 which makes you money. A Liability is debt or anything which 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. 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!

(Take a few and check out TMF's Retirement section, starting with this primer on planning )

"Mongo like machine-gun!"
One of the secrets of a well put together squad of soldiers is using each person in their best capacity. With an understanding of their strengths and their weaknesses. A small wiry man might make 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. Much better for that beefcake who bench presses 200lbs for fun. The same goes for your investments. You want each Asset working in the area of your financial squad to it's best capacity.

Time for some reading:
First check out "Foolish Portfolio Allocation" by Todd Beaird
then Moe Chernick's follow up "Do You Really Need Three Buckets?"

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 (with a nod to washu),
-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. This is after all your investments.)

Take the first list and begin by putting each Asset into which Bucket and then again in which Risk Category you think it belongs.

An Example:
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 44 years old, single with no children. His Assets are,
$950 a week in Paycheck
$3000 in a Savings Account
$11,000 in 1yr CDs headed towards a new car.
$20,000 in company 401K invested in an index fund.
$82,000 in a Roth IRA invested in 18 emotional stocks.

He has been foolish and has paid down his credit cards to $850, which he plans on having paid off by year's end. Other than that he has no debts. Adam spends about $2100 a month covering all his expenses.

For Adam's long-term goal, he would like to have a million dollars in Assets in 12 years, at 56. He could then consider retiring early at 59 1/2 when he can begin drawing from his IRA. His short-term objective is to buy a better car in 2-3 years. 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: $20K in 401K/Index Fund
High Risk: $82K in Roth IRA/Stocks

Pretty simple. This is all you really have to do as an "Investment Objective." With this 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.)

"You can juggle hand grenades, just don't pull the pins first!"
Let's take a moment and talk about Risk Management. Something arezi said, that we here on the boards repeat often:

"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."

ValorieRyan posed good questions on risk management, the replies are worth reading.

Looking at the above example, "Index Fund, medium risk? And stocks are high risk?" After the way the market has performed this year, anyone not think the market has it's 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 lose 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. So the important thing is not to take on too much risk to start. Build up you tolerance.

Two methods I have found work are diversity and limiting your exposure to high risk.

"Teamwork is essential, it gives the enemy someone else to shoot at."
The first way to mitigate risk is "Diversity".

*Numerical Diversity-
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 that's just not true.

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 wasn't foolproof after all, and an unqualified company becomes your selection. Oops, who is OMI?

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."

(The thread this post is from is well worth the read. Bcairns tries to use math to solve the diversity question. It continued in a second thread found here )

So how many stocks should you have in a portfolio? Time for more reading,
A well thought out post by Baltassar on diversity. The thread's good too.
Geocorona posted a great math explanation of diversity. Look also at TMFElan's response later in the thread.

*Diversity Within a Screen & Diversity Across Screens-
Additionally when dealing with portfolio allocation and risk management, you'll 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 Elan's simple example, once you get to 5 stocks deep in a screen the probability of picking all losers is about 1%. Note, that's "all stocks", not some. You can expect to have at least a few losing stocks whenever you use a screen. Sometimes you get lucky, but not often. From then on all diversity does is lessen your return. You gain very little additional protection by going deeper.

So it's better to go 5 stocks across two screens than 10 stocks deep in one. But only if the screens don't pick the same type of stocks. You wouldn't expect that a blend of RS13, RS26 & RS52 week screens would have much diversity. It pays to make sure the screens you use, pick from different areas. Also sometimes screens will intersect. Keystone is a good example. Recently it has been picking many of the same stocks as RS screens have, with the accompanying increase in volatility.

Take a look at this thread started by alevine for more

(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 by both screens in common. Screens that pick much of the same stocks will not give you diversity. Look for screens that pick different stocks in the same time period.)

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 is over diversified. "Diversity is the crux for poor due diligence." The implication 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 to do poorly with some stocks, 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."


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 (see Part 2). Don't buy so many stocks you have difficulty managing your portfolio.

Most people find that 12-18 stocks works well.

*Time Diversity-
You'll 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.

JimDS sums this up in a good post on Blends and Diversity. Worth the read
"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."

So for true diversity, you'd 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. It would take a broad market downturn to effect all your stocks. Just as we saw in early April. It is interesting to note, that during late last year, 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.

*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.

An 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 reduced your risk in half.

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's 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.
(look for other threads with the word "millionaire" in them)

Accepting less diversity is one case where you need to seriously weigh your options. No one can make the decision for you.

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

There is 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, still options are 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. Sometimes even two in a row. Keeping less than 10% of your portfolio 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 lose you, you keep yourself in the game.

Something else. People will often focus on blend 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."

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!"

A great primer on Margin by BAGoldman

You can see where a conservative use of margin, in the 20-30% range could help you "juice" your returns, but that level of margin would also increase any loss, and magnify volatility. Best advice I can give, "Until you are comfortable with the kind of volatility the screens have, stay away from Margin."

One Note: A 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.

"A Purple Heart just proves that were you 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 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: $82K in Roth IRA/Stocks

Recommendations and Advice: (& 55 cents gets you coffee.)
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. Take a look again at Moe Chernick's "Do You Really Need Three Buckets?" for more

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.

4)The Roth IRA and Mechanical Investing.

This brings us to the meat of the matter. Adam must decide how much of his IRA he wants to use mechanically and which screens he wants to allocate his money to.

This we will cover in Part 5.

"There is nothing more satisfying than having someone take a shot at you and missing."
Except perhaps having the market panic, and you don't. If you have exercised proper risk management you won't panic. Stocks go up, stocks go down, but mostly they go up. As we like to repeat, "Follow the screens."

Next up: Screen Mechanics
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