First of all, let’s talk about expectancy. The formula for expectancy is:

(win rate X win percentage) – (loss rate X loss percentage)

Smith gives an example of two traders — Lotto and Ergo:

Lotto stinks as a trader. When Lotto goes long, Ego goes short. Lotto’s so bad, in fact, his success rate is no better than 10%. But every once in a while, he stumbles across a winner. A big winner, which he has the perseverance to ride home until he’s up nearly 50%. Even better, while he gets a lot of losers, he’s smart enough to fold as soon as his position is 4% or so into the red.

Ego, on the other hand, prides himself on having fantastic entry signals. If MACD is crossing the fast stochastic, while the ADX line is retreating to the north, then that’s his signal! And he’s almost never wrong. Want a winner? Come to him because 80% of the time that’s what he has.

Unfortunately, to get those winners he needs to grab his profits and run. No, he doesn’t wait around, but instead when his position is up 3%, he dashes. Of course, they don’t all go up 3% immediately so he needs to give them some room. But he’s not stupid, so he’ll only let them fall 7% and then he’s gone.

So, with all that, who’s the better trader, Lotto or Ego? Ironically, over the course of thousands of trades, both will come out in a dead heat. That’s right. On every trade their “expectancy” is exactly the same at 1%.

He also posts this amazing table:

Pretty remarkable, isn’t it? All kinds of win rates from 10% to 80%, but the results are the same — an expectancy of 1%.

The other Gary Smith article is about thinking about equity in an account the same way a retailer thinks about inventory. Smith gives an example of two more traders — Rich and Peter:

Rich and Peter are two successful traders. Both start the year with $100,000 of trading capital. After the first six months, they get together to discuss their results. Rich says he commits about $20,000 per trade and makes about two trades per day. And while his win rate is only 40%, when he does win, he makes a high percentage. He knows what really matters, though, is his expectancy per trade (again, see my May 28 column) and his is a very tidy 4%.

Peter agrees that expectancy is the key. He also commits $20,000 per trade, also makes about two trades per day and is ecstatic that his win rate is near 70%. However, he also knows that his big losses hurt his overall performance. Still, his expectancy is even better than Rich’s at 5%.

So, Rich and Peter are both happy. Both are making money, and they toast to the fact that while they take different approaches, both are equally successful traders. Still, Peter is a bit smug, thinking he is the slightly better trader.

But, then Peter asks Rich how much Rich has in his trading account. Rich replies that he is now up to $180,000. Peter’s jaw drops. He thought he was doing better than Rich, but his equity is only at $150,000. How can that be?

Posed this way, the answer should become clear: Rich must turn his trades more quickly than Peter. In fact, during that six-month time period, Rich’s average turnaround on his trades was only two days. Therefore, his “inventory” of equity was continually turning over, enabling him to get in 100 trades in a six-month period. With each trade yielding 4%, he made $80,000 (100 trades x 4% x $20,000/trade).

Peter, however, while having the better expectancy of 5%, didn’t employ his equity nearly as fast. He managed to close only 50 trades in the same time period, leaving him with $50,000 in profits (50 trades x 5% x $20,000/ trade).

Peter now understands. He now knows that win rate, loss rate, expectancy and profit are all secondary to profit per day. While he seemed to be the superior trader to Rich, his profit per day was only $450 (assuming 110 trading days, then $50,000/110 = $450). Meanwhile, Rich’s profit per day was $725 ($80,000/110 = $725).

So you may be thinking at this point that the answer is turning over inventory much faster. In other words, the answer is to trade on a very short-term basis. Not so fast, it’s not that simple.

Let’s look at the results of our SMR Portfolio so far. As of today, there have been 56 completed trades since 4/29/05. 76.8% have been winners and 23.2% have been losers. The winners have resulted in an average profit of 31.3% and the losers have resulted in an average loss of 9.6%. So the expectancy is:

(.768 X .313) – (.232 X .096) = 21.8%

What about inventory turnover? The average number of days to be in a position has been 132 days. So we’re turning over our inventory every 132 days.

How can we make improvements? First of all, I’m flat out embarrassed about a 76.8% win rate. That’s way too high and it gives people the impression that it’s sustainable. I assure you that it’s not. So look for it to come down.

The ratio of profits to losses of 32.3% to 9.6% is excellent — 3.4 to 1. That may be sustainable, but it’s going to be hard to make improvements there.

Where there may be an opportunity for improvement is in inventory turnover. If we could maintain something close to the same expectancy and at the same time increase inventory turnover overall profits would increase. But I would only want to increase turnover if it didn’t decrease expectancy by too much.

Smith puts it this way:

If you don’t get a handle on this stuff, you will never take your trading to the next level. It is not just about finding good trades and banging them out. And it’s not nearly as simple as “cutting your losses and letting your winners ride.”

No, there is a huge interplay between finding good candidates, win rates, expectancy, profit and profit per day.

So it’s a combination of factors that must be considered. The point is that I’m asked all the time about things like what I think about the market, or this stock vs. that stock, or technical patterns, or indicators, or the economy, or whatever. The truth is that I don’t think about those things very much. I’m thinking about money management.

Or as Gary Smith says — money management is everything.

Larry Holmes

In his book, Tharp researches four position sizing models: one unit per fixed amount of money, equal value units for stock traders, percent risk, and percent volatility.

Testing a simple breakout system and assuming a million dollar stock portfolio with a 0.5% cost of trading and taking 595 trades over a 5.5 year period, the system had 273 winning trades and 322 losing trades. So only 45.9% of the trades were profitable. Here are the results of Tharp’s tests as applied to all four position sizing models:

One Unit Per Fixed Amount of Money: This model buys takes a one unit position per so much equity. It’s commonly used by futures traders. For his tests, Tharp used 100 shares of stock per $100,000 in equity. It made $237,457 for an annual compounded rate of return of 5.75%. It had a maximum drawdown of equity of 7.13%.

Equal Value Units for Stock Traders: Stock investors use this one a lot. For this model, Tharp allocated 3% of his equity for each position. So for a million dollar portfolio, no position would be larger than $30,000. In other words, you would buy 1,000 shares of a $30 stock and 300 shares of a $100 stock. It made $231,121 over the period for an annual compounded rate of return of 3.86%. It had a maximum drawdown of 3.72%.

Percent Risk: For this model, Tharp sized his positions at a 1% risk. Since 1% of a million dollars is $10,000, the initial risk could be no more than $10,000 for each position. So if you bought a $30 stock with a stop loss at $24 (20% below the entry price), you would risk 0.5 percent of the portfolio (.01/.20). With a million dollar portfolio, you would buy $50,000 worth of stock. $50,000 divided by the $30 stock price means that you would buy 1,666 shares.

It made $1,840,493 for an annual compounded rate of return of 20.92%. It had a maximum drawdown of 14.44%.

Percent Volatility: For this model, Tharp used the average true range of the stock over the last 10 days. In other words, he factored in the volatility of the stock. He used a 0.5% volatility, which means that he wanted to limit his market volatility exposure to 0.5% per positon, or $5,000 in a million dollar portfolio. So if the average true range for a stock was $5, he would buy 1,000 shares ($5,000/5). If the average true range was $2, he would buy 2,500 shares ($5,000/2).

It made $2,109,266 for an annual compounded rate of return of 22.93%. It had a maximum drawdown of 16.61%.

Think about it. The exact same system was used for each model, producing the exact same entry and exit points and the exact same win/loss percentage. But the last two models made well over 700% more money than the first two. And the only difference among the models was position sizing.

Tharp said that the percent volatility model was probably best for “traders who use tight stops” and the percent risk model was probably best for “long-term trend followers.” Since most of what we do is closer to long-term trend following, we are using the percent risk model.

Larry Holmes

You will be asked about your present income. You know the answer to that one. You will be asked about your expenses. That one will be tough. Everyone underestimates their expenses because most of us have no idea what we’re really spending and what we’re spending it on.

You will be asked about your assets — what you own. You know what you own, but it will be tough to put a market value on some of it. You will be asked about your liabilities — what you owe. For most people, facing the reality of their debts is rather daunting.

You will be asked when you want to retire. I would say the average age most people give is 55 years old. I don’t know why that is, but 55 seems to be a popular number. Then the financial planner will tell you that you will need to accumulate enough money to live another 40 or 45 years after retirement. After all, if you live to 90 or 95 you don’t want to run out of money, do you?

You will also be asked about your risk tolerance so that the planner can determine what kind of annual rate of return to factor in for your investments. If you say you have a low risk tolerance, the planner will consider so-called low-risk investments that will give you a lower rate of return. If you say you have a high risk tolerance, investments that could provide a higher rate of return will be considered. You can’t have it both ways. If you don’t take risks, you can’t get a very high rate of return on your investments.

Then all that information will be dumped into a financial planning software program. The software will print out a plan that will say you need to accumulate several million dollars by the time you’re 55 years old. Oh, and it will be exact to the penny — something like $5,387,234.23.

You will look at the plan and you will think, “My gosh, there is no way I can do this!” You may get started doing a few things that the planner recommends. But it won’t last very long and you’ll go right back to doing things the way you’ve always done them.

So what’s wrong with the traditional financial planning process? Plenty. First of all, it’s ridiculous to try to look decades in the future to predict what’s going to be happening in your life. I don’t know about you, but I don’t know what’s going to happen tomorrow, much less decades from now. Also, traditional financial planning doesn’t take into account what financial freedom actually is. You’re financially free when your passive income (money you don’t have to work for) equals your expenses.

So if you have no passive income right now and your expenses are $50,000 a year, and you can get a 10% return on your investments, you need to accumulate $500,000 to become financially free. If you can get a higher return on your money, you can reduce the amount that must be accumulated. If you settle for a lesser return because you’re risk averse, you will need to accumulate more. You should also consider inflation. Of course, if you invest for inflation, it will already be factored into your investments.

Understanding financial freedom as the point where your passive income equals your expenses is a much more realistic way to look at it. Most people who are committed to being financially free can achieve their goal in a matter of a few years, not decades.

Larry Holmes

For example, during the secular bear market of the early 1930’s, five of the six bear market rallies gained more than 20%. In fact, from a low of 199 in November of 1929, the Dow rallied 48% to a high of 294 in April of 1930 only to be followed by a decline of 86% before reaching an ultimate bottom of 41 in 1932. Defining those rallies as bull markets would have caused long-term investors some serious financial set backs.

So those rallies were obviously not the beginning of secular bull markets and I don’t think today’s stock market is a secular bull market either. In fact, you can include me in the circle of the minority of market observers — a minority that seems to include some of the most experienced investors — who believe that the rally that has taken place since 2003 is nothing more than a very strong and long bear market rally that will result in the resumption of the secular bear trend.

I think the secular bull market — the most powerful bull market in history — that began in 1982 ended in early 2000. It also signaled the beginning of a secular bear market that hasn’t didn’t come close to ending when stock prices bottomed in 2002. And you need to look no further than price/earnings ratios for proof.

*The P/E ratio is based on the S&P 500 as developed and presented by Robert Shiller in Irrational Exuberance.
** The returns reflect the Dow Jones Industrial Average at year-end.
Source: Crestmont Research

There are two things you should learn from the data. The first is that since 1900, investing in the stock market during periods of high price/earnings ratios has resulted in inferior investment returns. The other thing is that, without exception, new secular bull markets don’t begin until p/e ratios get to single digits.

And there’s a logical reason for that kind of market behavior. Bull markets tend to go a lot higher and last a lot longer than anyone expects. Conversely, bear markets tend to go a lot lower and last a lot longer than anyone expects.

This phenomenon occurs because the final stages of secular bull markets are always fueled by excessive speculation, whereas the final stages of bear markets result in investors deciding that they can’t stand any more pain, the market is never going to come back again, so they just want out at any price. And when that occurs the news will be terrible and stocks will be dirt cheap. And yet nobody will want to touch them. That’s how bear markets end.

So where are we now? Not even close to a market bottom. In fact, we’re much closer to a historical market top than to any kind of bottom. Right now the p/e ratio for the S&P 500 index is about 18, still relatively high. So the current bear market has a long, long way to go before a new secular bull market can begin.

The market can get to low p/e ratios in one of two ways. Either the S&P gets so low that the p/e ratio for the index drops below 10. That happened during the bear markets of 1929-1932 and 1937-1941. Or the S&P could go through a very long period of sideways action while earnings catch up to price. That happened during the bear markets of 1921-1920 and 1966-1981.

I went through the last half of the one from 1966-1981 and I can tell you that even though the market ended that period about where it began, there were very powerful up and down moves during those years. However, the end result was that it was not a good time for long-term stock market investments.

Finally, I think that the current stock market is on the verge of a steep decline. All of the reasons for that are beyond the scope of this article but I’ll give you one that I consider quite telling. According to the Commitments of Traders report (COT), the net short position of commercial traders for the S&P futures contract is one of the largest in COT history. Ever since the secular bear market began, such a bearish position on the part of the “smart money” has signaled a steep market sell off within the next few months.

We shall see what transpires.

Larry Holmes

What are exchange traded funds? ETFs are similar to index mutual funds. Essentially, an ETF is a portfolio of securities that is intended to provide investment results that, before fees and expenses, generally correspond to the price and yield performance of the underlying benchmark index. ETFs trade on the stock exchanges. As such, they offer features of a mutual fund in a stock-like instrument.

There are at least six important advantages that exchange traded funds have over mutual funds:

1. ETFs, instead of pricing once a day after the market closes (like mutual funds), are traded throughout the day as if they were regular stocks.

2. Since an ETF trades like a stock, it can be bought and sold (and shorted) at any time during market hours.

3. Investors can calculate the value of an ETF during the day because the composition of the underlying portfolio – normally a published index – doesn’t change. For example, the value of the SPDR ETF (SPY) that tracks the S&P 500 index is calculated continuously throughout the day.

4. An ETF can be exchanged for the underlying assets it represents with the issuing institution for a small fee. It means that ETFs will not trade at significant discounts or premiums to the value of the underlying assets of the fund. This is not true with closed-end mutual funds.

5. Because they are not actively managed and have very little portfolio turnover, ETFs carry some nice tax advantages over mutual funds because they distribute relatively few capital gains.

6. Most ETFs have very low management fees, especially compared to mutual funds. And the lower the expenses, the more money goes into the investor’s pocket.

So exchange traded funds offer most of the advantages of mutual funds — instant diversification and many to choose from — without the major disadvantages.

The primary disadvantage of an ETF is that if you are making small transactions on a regular basis, you will pay a commission on each transaction — just like you would by buying and selling a stock.

But, all in all, the advantages of an exchange traded fund far outweigh any disadvantages. I suggest that you use ETFs as an important part of your investment strategy.

Larry Holmes

Number 1: Identify Major Investment Themes

In early 2003, we identified our favorable and unfavorable major investment themes for the next 10, 15, 20 years or so:

Favorable investment themes:

Gold and silver
Oil
Other commodities
Emerging markets

Unfavorable investment themes:

U.S. stocks (with certain exceptions)
U.S. bonds
U.S. real estate

Our favorable investment themes are the ones that were in primary bear trends for many years. As a result, they are the markets that are the most undervalued. On the other hand, our unfavorable investment themes are the ones that were in primary bull trends for years. They are the markets that are relatively overvalued.

Markets tend to go from relatively undervalued to relatively overvalued and vice versa. The process can take many years to complete. Concentrating on the big picture of our investment themes allows us to stay focused and not get distracted by counter-trend market corrections and noise emanating from Wall Street and the financial media.

Number 2: Asset Allocation

We allocate assets to emphasize favorable themes and de-emphasize unfavorable themes. For example, 10% of our overall portfolio is allocated to the ownership of gold and silver. We view that part of our portfolio as an insurance policy on a weakening U.S. dollar. We don’t expect that to change for at least several years.

The other 90% is allocated to profit when one of our favorable investment themes rise in price or when one of our unfavorable investment themes decline in price. As a result, we often have additional investments in gold and silver stocks and Exchange Traded Funds (ETFs) over and above our permanent 10% portfolio allocation.

Number 3: Let Profits Run And Cut Losses Short

A substantial percentage of our overall portfolio is allocated for the purchase of shares of stocks and ETFs. With this part of our portfolio we typically use trailing stop loss orders to allow our profits to run and to cut our losses short.

A trailing stop loss order is one in which the stop loss price is set below the market price. The trailing stop loss price moves incrementally with market price. This technique allows an investor to set a limit on the maximum loss without setting a limit on the maximum gain, and without requiring paying attention to the investment on an ongoing basis.

The stock selection in our portfolio are shares of companies that are either earning a high return on invested capital and are priced at a high earnings yield or shares of companies and ETFs representing one of our major investment themes.

Number 4: Position Sizing

We are firm believers in the fundamental truth that if you keep losses at a minimum, profits will take care of themselves. Therefore, we size our positions so that we rarely risk more than 2-3% of the equity in our stock portfolio on any one stock or ETF position.

The question that the average investor asks before making an investment is how much can I gain? That’s the wrong question. The right question is how much can I lose? We try to never forget asking the right question.

Number 5: Discipline

The typical investor is always searching for the “Holy Grail” investment strategy. There is no Holy Grail except for the discipline of the individual investor.

The best investment strategy in the world will have long periods of underperformance. Therefore, we realize that we must stay disciplined by staying the course when we are going through one of those periods.

Let me quote a passage from chapter 8 of Joel Greenblatt’s amazing book, “The Little Book That Beats The Market“:

Let’s take a look at the experience of a good friend of mine who happens to be the “smartest money manager I know.” Though he doesn’t automatically buy stocks that his computer-based formula spits out, he does follow a disciplined strategy of choosing companies to buy only from the list of companies his formula ranks the highest.

He used this strategy for 10 years at his previous investment firm, and nine years ago he set out to form his own money management firm using the same basic principles. Business wasn’t too good for the first three or four years, as the same strategy that had been so successful in the past drastically underperformed the returns of competing money management firms and the major market averages. Nevertheless, the “smartest money manager I know” strongly believed that his strategy still made tremendous sense in the long run and that he should continue following the same course as always. Unfortunately, his clients disagreed. The vast majority of them ran for the exits, pulling their money away in large numbers, most likely to give it to a manager who, unlike my friend, “knew what he was doing.”

As you guessed, they should have stuck around. The last five or six years have been so good for my friend and his strategy that now the investment record of his firm since its inception (once again, including those tough first few years) has trounced the returns of the major market averages over the comparable time frame. Today it stands among the top of only a small handful of firms with extraordinary investment records out of the thousands of investment firms on Wall Street. To prove that sometimes good things do come to those who wait, my friend’s firm now manages over $10 billion for hundreds of clients. Too bad that, in the face of several years of underperformance, most chose not to wait. Only four original clients remain [Joel Greenblatt is one of them].

The point of the story is that if a winning investment strategy always worked, everybody would follow it. And if everybody followed it, it would stop working. The reason that most people lose is that they lack the discipline to stay with a winning strategy while it goes through an inevitable period of underperformance. So, above all, we focus on being disciplined.

Larry Holmes

Here’s what happens — the government, specifically the Commodity Futures Trading Commission (CFTC), requires all those who hold a number of futures contracts above a specified limit to report their positions. For example, the threshold limit for S&P futures is currently 1,000 contracts. So only the really big players have to report. But they hold 70% to 90% of all outstanding futures contracts. You may view the reports for the various markets at the Commodity Futures Trading Commission Web site.

The report is released on Fridays (except for holidays) based on data as of the previous Tuesday. So the information is released three days after the fact. That’s OK, because it’s timely enough to be valuable.

The column headings at the top of the report will be labeled NON-COMMERCIAL, COMMERCIAL, and NONREPORTABLE POSITIONS.

When an account is reported to the CFTC as holding positions above the specified reporting level number of contracts, the CFTC determines if the account is a commercial hedger or a large speculator.

Commercial – The CFTC classifies a futures account that meets the reporting level as a “commercial” when that account holder files a statement with the Commission that states it is commercially engaged in business activities hedged by the use of the futures markets. They’re the ones that we’re most interested in. For example, the commercial traders of S&P futures are the largest institutional players like banks, pension funds, mutual funds, hedge funds and the trading arms of Wall Street firms.

Non-commercial – Those classified as non-commercial are “large speculators.” They don’t deal with stocks as a part of doing business. An example of a large speculative account might be a large commodity pool (a fund) that trades futures for speculative profit. Managed futures accounts have grown into the billions of dollars and if they meet the reporting levels, their positions would be reported to the CFTC for monitoring.

Nonreportable positions – All traders, speculative and commercial, that have smaller positions than the reporting level are considered the “small speculators.” In other words, they’re everybody else who participates in the futures markets — the proverbial “little guys.”

To know how to use the COT data, it’s important to take a closer look at the three types of players that are the report’s focus — the commercial trader, the large speculator, and the small speculator. We want to know what makes each of them tick.

Commercial traders dominate the market. That fact really shouldn’t be a surprise to anyone given the nature of who the commercials are. For example, in the S&P futures market they are banks, pension funds, mutual funds, Wall Street brokerage houses and the like. They have vast research departments and have inside information that simply is not available to the average investor in a timely manner.

They also dominate because of their sheer size. They are so large that they actually become the market. So the commercial traders are the ones that we’re most interested in. We want to try to determine what they’re doing and tag along. History has shown that the commercial traders in most futures markets for that matter are right a great deal of the time. And when they’re wrong, they are rarely wrong for very long. They will eventually end up on the right side of the market, whether it be on the upside or downside.

The large speculators tend to be trend followers. After the market has established a trend up or down, they will go the direction of the trend. It’s interesting to know what they’re doing in the market, but it shouldn’t be critical to your decision making process.

The small speculators are usually on the wrong side of the market. In fact, it has been estimated that as many as 90% of small traders lose money in the futures markets. They tend to serve as “cannon fodder” for the big commercial traders. After all, the “smart money” has to have someone to take the opposite side of their trades. The small speculator is usually willing to accept that roll. Think of the Harlem Globetrotters vs. the Washington Generals. The commercials are the Globetrotters. The small speculators are the Generals — the patsies who are bound to lose.

The commercial traders are the ones to follow. They’re the smart money. When they have an extreme long or short position in relation to their positions in the past — or in the case of S&P futures, even when they are net long or short — it is a very useful indicator to help determine market direction.

Larry Holmes

Over time, small cap stocks perform better than large cap stocks. The record is clear about that. However, in reading the commentary offered by investment pundits and Wall Street analysts there seems to be a heavy dose of skepticism about whether small stocks are appropriate for a significant percentage of an individual investor’s portfolio.

One reason for this skepticism is risk. It is true that small cap stocks are much more volatile than their big cap brethren. So in that sense, there is more risk involved. But there is also an attitude among the investment elite that the individual investor is too unsophisticated to handle risk. Therefore, individuals must be protected from themselves by limiting their small cap investments to a small percentage of an overly diversified portfolio.

The last thing that Wall Street types want to do is empower you to make your own decisions. After all, if you’re calling your own shots you don’t need to pay for their advice, do you? And since Wall Street doesn’t cover small stocks, it’s in their best interest to steer you away from small stock investing.

But the truth of the matter is that it’s the very reason that Wall Street doesn’t want you to focus on small cap stocks that gives you an advantage. Analysts for big investment firms don’t cover the little stocks. There are just too many of them and they are too small and illiquid for their big institutional clients to buy. And since many small stocks aren’t adequately covered, they can be very inefficiently priced. That inefficiency offers a great opportunity to those who are willing to do the research to uncover hidden gems.

Super-star investor, Warren Buffett, has written, “Observing that the market was frequently efficient, the theorists went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day.”

Buffett is saying that smart investors can find opportunities in stocks that are priced below their value.

However, if you think you’re going to get an edge by investing in Wall Mart, Microsoft, General Electric, and the like, you’re just kidding yourself. Those stocks have been analyzed to death by teams of Wall Street analysts. What is known about them is already priced into the stock. There is no way you’re going to be able to uncover information that is not already widely known by everyone else.

That’s not true with small cap stocks. If you do your homework, you can find some really undervalued investment opportunities. You do have to manage your risk. But that’s always the case in any investment you make. So don’t let the financial media and Wall Street elites keep you from using the biggest advantage that you have over them — the ability to find investment opportunities that they can’t take advantage of. And you’re going to be able to find those opportunities within the ranks of small cap stocks.

Larry Holmes

1. Get out of debt and stay out of debt.

There is good debt and there is bad debt. There’s only one kind of good debt — the kind that’s going to make you money. Carefully considered business debt can be good debt. Investment debt can be good debt in certain instances. Mortgage debt can be good debt if you work to pay off a mortgage as soon as you can.

Almost all other debt is bad debt. Consumer debt like automobile loans, loans to buy appliances and furniture, loans to buy boats, motorcycles and the like — they’re all bad. And credit card debt is terrible debt.

The big problem with debt is that you have the magical power of compound interest working against you rather than for you. The average American has $8,000 in credit card debt. If that’s you and you’re making the minimum payment, it will take you 26 years and 8 months to pay what you owe. And you will end up paying $11,423 in interest.

I hope you enjoyed whatever you bought for that $8,000 because it will be the most expensive $8,000 you ever spent.

2. Save 10% of your gross income by using the 60/20/20 rule.

And the only way to do it is to pay yourself first. Let’s say that your gross income is $5,000 a month. The first $500 automatically goes into savings and investments. Set up an automatic deduction plan where you don’t even see it. It automatically goes into a savings account. Saving is not an option. So consider it a necessary expense just as you would food, utilities and a mortgage payment.

The 60/20/20 rule means that 60% of what you save is allocated to long-term investments. 20% is allocated to an emergency fund. And 20% is allocated for “emotional spending.” Long-term investments are critical for achieving financial freedom.

An emergency fund is important for…well…emergencies. Traditional financial planning says that you should have about six months living expenses set aside for emergencies — those “unexpected” things that happen like a loss of a job, or unplanned medical expenses, or major repairs.

Emotional spending is defined as spending for things you want, but don’t necessarily need — vacations, a new TV, down payment on a second home, and all the “stuff” people like to accumulate. An emotional spending account is important because that’s what makes saving money fun. And you want to have fun doing this.

So here’s an example of how this could work…

We will use as an example a gross income of $5,000 a month. Let’s say at first you can only save 2% . (Remember you’re also paying off your debt at the same time. You’re going to eventually be saving 10% of your income. But you have to start somewhere, even if it’s only 1% or 2%.)

So you’re saving $100 a month (2% of $5,000). Here’s how $100 would be allocated according to the 60/20/20 rule…

$60 into a long-term investment account like a 401(k) account, a Roth IRA, etc.

$20 into an emergency savings account like a money market fund

$20 into an emotional spending account. This portion could also be put into a liquid account like a money market fund. However, if it’s for a longer-term goal, you may want to put it into a certificate of deposit or a bond mutual fund to get a higher rate of return. If you put it in the same account that you have for emergencies, make sure you know how much of that account is for emergencies and how much is for emotional spending.

As you increase the amount you are saving you will increase the amount going into the three categories. The allocation stays the same until you have about six months of savings in your emergency savings account.

Then you could change the allocation to 80/0/20. In other words, 80% allocated to long-term investments and 20% allocated to emotional spending. You no longer need to save for emergencies because you’ve reached your goal in funding that account.

Simple but powerful.

3. Buy a house and pay off the mortgage.

The advantage of home ownership has been well documented. The idea of paying off a mortgage early is more controversial. Some would say that if you have a 6% mortgage and you can earn more than that by investing the difference, you shouldn’t pay off the mortgage.

I disagree. First of all, whatever you can earn over and above the 6% is not guaranteed. Paying off the mortgage is guaranteed. Let’s say you have a $180,000 30-year mortgage at a 6% interest rate. If you make the minimum payment of $1,079 a month on that loan for 30 years, the real cost of that mortgage will be $388,508. Not nearly as bad as credit card debt, but not nearly as good as having money work for you.

Also, there is a psychological factor that goes way beyond dollars and cents. It’s a wonderful feeling to own a home free and clear. So pay it off.

4. If you’re eligible, open a Roth IRA account.

The Roth IRA is the simplest, easiest, most effective tax-free savings plan imaginable. Not only do your earnings accrue on a tax-free basis, but withdrawals are free of taxes as well.

If you’re confused about the myriad of retirement plans that you have to choose from, let me make it easy for you. The Roth IRA is probably going to be your best bet, hands down. It’s more flexible than a 401(k) or a traditional IRA and it will probably allow you to accumulate more money for retirement.

I can think of one exception where the 401(k) may be better. If your employer matches your contributions, you probably want to contribute to a 401(k). But contribute to it only to the point that your employer matches your contribution. Beyond that, put your money in a Roth IRA. And even if your employer matches your 401(k) contribution, it is usually the case that you have to stay with the company for a certain number of years before you actually own your account. If you don’t plan to be there that long, then opt for the Roth IRA.

For 2006, the contribution limit to a Roth IRA is $4,000 if you’re under age 50 and $5,000 if you’re 50 over. However, there are proposals before Congress to raise that limitation or remove the limitation altogether.

If you’re single and your adjusted gross income is higher than $95,000, or $150,000 if you’re married, the amount you can contribute to a Roth IRA begins to decrease. It reaches zero for incomes of $110,000 for single people and $160,000 for those who are married. But there are proposals to remove the ceiling, making all Americans eligible.

The big attraction to the Roth IRA is the tax break it gives you. If you contribute to a 401(k) or a traditional IRA, you get a tax deduction in the year of your contribution, which reduces your taxes for that year. And you won’t pay taxes on interest, dividends, or capital gains while you’re working. But you will pay taxes when you go to withdraw the money at retirement.

With a Roth, you don’t get the tax reduction on contributions, but after that it’s completely tax-free. You never pay taxes on interest, dividends, or capital gains — not while it’s growing, not when you make withdrawals. Never. That’s a huge benefit.

Also there are no distribution requirements with a Roth. Remember that a 401(k) account and a traditional IRA are just tax-deferred, not tax-free. The government wants its money when you make withdrawals. So you are required to start making withdrawals at age 70 1/2. But since Roth IRAs are tax-free, the government doesn’t care how long you let it grow. So if you don’t need the money you can just keep letting your account grow, free of taxes, for as long as you want.

Withdrawals from a traditional IRA or an employer-sponsored retirement plan before the age of 59 1/2 could lead to taxes and penalties. That may not be true with a Roth IRA. You can withdraw the money that you contributed at any time without penalty. However, the earnings on your contribution may be subject to tax and penalties. So a Roth also has an advantage over other retirement plans if you plan to retire early since you can first remove your contributions without tax or penalty.

If you appreciate the tremendous advantages of tax-free savings and investing, the Roth IRA is hard to beat.

5. Learn to invest like the best.

Maximize the return on your investments by buying a partial interest (shares) in good businesses when you can buy them at a bargain price. That means you want to buy shares of businesses that have a high return on capital when the shares are selling at a high earnings yield. And that’s what this site is all about.

Other than making sure your insurance needs are taken care of, that’s it. Do the above five things well and you’re not likely to ever have a significant financial problem.

Larry Holmes

In fact, two-thirds of our current portfolio consists of Magic Formula stocks. Currently, those stocks are up over 60% on average and we’ve only been in them for an average of about five months. So the Magic Formula works.

Now that the publicity over the book has died down in favor of new hot-off-the-press investment books (everybody’s looking for the Holy Grail), I think it would be a good time to review the main points of the book.

What Can You Do With Your Money?

Greenblatt makes the point that you only have a few basic alternatives for what you can do with your money. You could put it under a mattress. But that hasn’t worked very well for the people who have tried it. You could buy U.S. government bonds. At least you’re guaranteed to get your money back with some interest. You could buy corporate bonds and get more interest, but you may not get your money back. Or you can buy partial interest in businesses.

What It Means To Buy a Partial Interest in a Business

When you buy shares of stock you’re buying a partial interest in a business. You own a portion of that business’s future earnings. The worth of the business depends on how much the business will earn in the future. In order for it to make sense to buy a partial interest in a business, your share of the profits must be more than you can get from owning a risk-free U.S. government bond.

The Behavior of Stock Prices

Ben Graham (the father of value investing and Warren Buffett’s mentor) described stock price behavior with his famous “Mr. Market” metaphor. Imagine that you have a business partner named Mr. Market. Mr. Market is kind of a strange guy, subject to wild mood swings. Every day he comes into your office and offers to sell you his interest in the business. His price is different every day and he leaves it up to you whether or not you want to accept his deal. Some days he wants to sell at a price that is too high and some days he wants to sell at a ridiculously low price. It’s completely up to you. He doesn’t even seem to care if you accept his offer. He just keeps coming in every day with a new offer.

Warren Buffett has described it this way. As an investor, you’re like a batter in baseball. You patiently stand at the plate and wait for a good pitch to hit. Except in this game the umpire is not going to call you out on strikes. You can just take pitch after pitch until you get a good one to hit. Eventually the pitcher will make a mistake and serve you a fat pitch right down the middle of the plate. That’s the one you want to hit out of the park. The key is to wait for your pitch.

That’s the way the stock market works. Stock prices move around crazily over the short term, but the value of the business doesn’t change. If you’re patient, you will have an opportunity to buy a partial interest (shares) of a good business at a ridiculously low price.

Buying Shares of Good Businesses at a Bargain Price

You want to buy shares of good businesses when they are selling at a bargain price. In other words, you want to buy when a good business has a high earnings yield. You know if it’s a good business if it can invest its own money at a high rate of return. And that means you want businesses that earn a high return on capital.

So to make money — maybe a lot of money — all you have to do is buy shares of good businesses (high return on capital) when the shares are selling at a bargain price (high earnings yield).

The Magic Formula

Here’s the Magic Formula:

To identify good businesses, use the following Return on Capital formula:

EBIT/ (Net Working Capital + Net Fixed Assets)

“EBIT” stands for earnings before interest and taxes. “Net Working Capital” is working capital minus interest-bearing current liabilities and excess cash. To get working capital subtract current liabilities (less interest-bearing current liabilities) from current assets. Greenblatt doesn’t explain how he computes excess cash. But if you consider any cash that’s on the balance sheet that’s above 5% of annual sales to be excess cash, you’ll be in the ball park.

To identify when good businesses are selling at a bargain price, use the following Earnings Yield formula:

EBIT/Enterprise Value

“Enterprise Value” is the market capitalization of the stock (the price of the stock times the number of shares outstanding) plus total debt minus cash and short term investments.

That’s all there is. According to Greenblatt’s extensively tested research, owning a portfolio of about 30 stocks that have offered the best combination of Return on Capital and Earnings Yield would have returned about 30.8% per year over the 17 year period from 1988-2004.

And you don’t have to do the research yourself. Greenblatt has made it really easy for you. Every day he lists the stocks that have the best combination of Return on Capital and Earnings Yield on the Magic Formula Web site. It doesn’t get much easier than that.

Why the Magic Formula Will Continue To Work After Everybody Knows About It

Here’s the most important thing you need to know about the Magic Formula. The reason the Magic Formula will continue to work after everybody knows about it is that it doesn’t always work. I know that sounds counterintuitive, but I can tell you from my experience of many years of working with people and their money that it’s the absolute truth.

The deal is that the Magic Formula can under perform the market for months and years at a time. And the number of people who have the discipline to stick with a winning system during the periods of underperformance are few and far between. As soon as it starts underperforming, most people will abandon it in favor of something else.

The great trader, Richard Dennis, once said that he could publish his exact system in the Wall Street Journal and it wouldn’t matter because people would not have the discipline to follow it.

So this is wonderful news for people who understand what I’m talking about — the Magic Formula will continue to work precisely because it doesn’t always work.

Conclusion

The above is just a summary. You need to read the book to know how Greenblatt conducted his research and to get all the details. The book can be read in just a couple of hours.

Greenblatt suggests that you buy any 20 or 30 Magic Formula stocks. He suggests holding them for one year before selling (adjusting the holding period by a few days one way or the other for taxable accounts). And then buy more Magic Formula stocks that you will hold for a year. On this site, we don’t do it that way. As Greenblatt says in his book, there will be those who find other profitable ways to use the Magic Formula.

We use the Magic Formula Web site as our primary screening tool. We start with the list of stocks that are on that site and research them from there to find the ones we think will continue to have earnings increases in the future. Also, we choose the ones that are in what we think are the most promising sectors. And we don’t buy 30 stocks as Greenblatt suggests. We buy no more than 10. In addition, there are some other things we do that are different to manage our risk.

However, if you’re inexperienced I suggest you do it exactly as Greenblatt recommends. It’s an important book. Read it. You’ll be glad you did.

Larry Holmes