By Todd Beaird (TMF Synchronicity)
June 13, 2000

Here at The Motley Fool, we have a number of different stock strategies. A quick look in our strategies area reveals Rule Breakers, Rule Makers, a dividend reinvestment (DRIP) portfolio, and a few others in addition to our Workshop. Why so many strategies? Why not just choose the strategy that works?

The quick answer is that all of these strategies have "worked," but they approach investing in different ways. Rule Breaking searches for up-and-coming companies with the potential to dominate. Rule Makers are companies that are already dominant and likely to remain so.

There are many ways to invest well. The most important point for any investing strategy is that it be right for you. If a strategy isn't a good "fit" for your personality, then you'll likely abandon it at the worst possible time. If you are emotionally primed to jump into a "hot" investment strategy, but leave it when it gets "cold," you're basically buying high (hot) and selling low (cold). This is not the way to invest successfully!

So, how do you know if Mechanical Investing strategies are right for you? Here's a quick series of questions to ask yourself.

1) Are my personal finances in order?

You've probably heard this a hundred times here at the Fool site, (it's Step Two of the 13 Steps to Foolishness), but it bears repeating: You should only invest money in the market for the long-term! We define "long-term" as at least three years, preferably much longer. Savings that you need for the next month's rent belongs in a money market account. Maybe you're sick of paying rent and are saving money to buy a house next year. If you really need to buy that house, that money belongs in bonds or CDs or (possibly) a low-expense, short-term bond fund.

Although The Motley Fool focuses on stock investing, we also have a message board devoted to Bonds & Fixed Income Investments. In addition, you can read my thoughts on "portfolio allocation" (and Moe Chernick's thoughts, as well).

You should also pay off any high-interest debt before putting money in the market. Wanna make an 18% return, tax-free, guaranteed! Pay off your credit cards! I know how tough it is from personal experience, but it's well worth it. And we have an entire message board filled with people doing the same thing, sharing tips and stories about defeating the debt dragon.

So once again: get your finances in order before you invest.

2) Do I look predominantly at quantitative factors, or do I focus on more subjective criteria?

Another way of saying this is are you a "numbers person"? Our screens pick stocks based on objective factors (relative strength, or P/E ratio compared to earnings growth, or some other combination of factors). We don't believe that every stock picked by a screen will be a winner. However, we believe that over time, the "basket" of stocks chosen will outperform the market.

Some people focus on more subjective criteria in picking stocks. The Rule Breaker portfolio is a prime example (just look at the RB principles). Here at the Workshop, we develop screens with objective rules, and backtest them. If you are more comfortable with subjective rules, then Mechanical Investing may not be for you.

3) Am I a "stock-picker"?

Some people view investing as an intellectual challenge. They enjoy digging through annual reports, news releases, and earnings estimates. They believe that they can see something others can't, and take great pleasure when that hard work pays off.

The Rule Maker portfolio is an example of this approach. Like our Workshop strategies, the Rule Maker uses many quantitative criteria in choosing stocks. Unlike the Workshop, they select a few choice stocks and plan to hold them for a very long-time (ten years or more). Tom Gardner may be a "numbers guy," but I suspect that he would not follow a Workshop strategy.

Here in the Workshop, we don't try and find those few diamonds in the rough. Instead, we filter stocks through our screens, expecting to find some gems and some costume jewelry. Again, over time we expect to find more gems than if we simply purchased an index fund. So far our strategies have rewarded us.

4) Can I handle volatility?

All stock investments are volatile, even when you're simply following an index. Unlike an index fund, we're not selecting a pool of several hundred stocks. Our strategies usually require you to hold the top five stocks selected by one of our screens. Also, many of those screens select stocks that are more volatile than average. Even if you build a diversified portfolio of stock strategies, there are bound to be some big swings up and down.

Before you jump into any investment strategy, you need a good idea of how much downside risk you can handle. (Interestingly, most people don't have a problem with upside volatility). How would you react if your stock portfolio dropped 20%? 30%? 50%?

The question isn't "how would your portfolio balance be affected?" The question is "how would you react emotionally?" Be as honest with yourself as possible. If a 30% drop would cause you to panic, then think twice about how much you want to invest in a mechanical screen. Also, be sure to check the historical volatility of our screens before you invest. If you are going to sell when your stocks drop, then you won't stay in the strategies long enough to reap the rewards.

5) Can I let the strategies work for me, or will I have to "do something"?

Our mantra here at the Workshop is "Follow the Screens." We let the mechanical strategies do the work for us and resist the urge to meddle. It isn't always easy (just ask those of us who sat through the meltdown from mid-March thru mid-April), but we've been richly rewarded.

Following the screens requires a Zen-like attitude. When times are worst, the best thing to do is to usually nothing. As TMFElan says, "Don't just do something, sit there!" If you have confidence in your strategy, you follow it the same way you did when things were going well. With our mechanical strategies, this means sitting on your hands until your next rebalance date. If you can't force yourself to do that, then our mechanical strategies may not be for you.

Now for a practical concern:

6) Do I have enough money to start?

Just last week, David Trammel (LAPropDoc on the boards), wrote about the costs of our strategies. As you can see from his article, quarterly and monthly trading costs can be a huge drain on all but the largest portfolios.

If you have less than a few thousand dollars, you're best bet may be to invest in an index fund. Another possibility is investing in a few select stocks through a Dividend Reinvestment Plan (DRIP). DRIPs allow you to purchase stock directly from the company. We even have a DRIP portfolio with advice to help you get started.

There are drawbacks to DRIPS. Setting up a DRIP plan may involve more work than setting up a brokerage account, and purchases are usually done at set times rather than the day you make your deposit. Also, tracking capital gains, so that you can eventually pay the taxes when you sell your stock, requires a serious commitment to paperwork. But if you're just starting with a few hundred dollars, a DRIP or an index fund may be the best choice. There will always be time to invest in mechanical strategies once you've built up a larger account.

So, if you've decided that Mechanical Investing (MI) is right for you, you might ask:

How have these strategies performed?

You're in luck! Next time I'll be listing many of our Workshop strategies, with the average returns and their volatility. In the meantime, you can look up some of the numbers yourself at Jamie Gritton's and Brian Finney's websites.

Until then, Fool On!