First, note that the default settings for System Restore are almost always needlessly wasteful. At the very least, you should manually control the size of the Restore area so that it's not consuming huge amounts of disk space.
Beyond that, the ideal approach for you depends on how your system is set up, how you use it, and whether or not you make regular, full backups:
For users with fast PCs and large hard drives, the "Simple" option discussed above is probably best. With a large hard drive, losing 200MB is not a big deal; and with a fast CPU, you won't be impeded for long when the system decides it's time to create an automatic Restore Point. As long as you also make regular, full backups to protect the files that System Restore doesn't monitor, you'll be well guarded against both the smaller kinds of problems System Restore can fix, and also major trouble that can wipe out not only your system files, but also your data files, too.
The "Extreme" option may be best if you have a slower system, or don't want to lose disk space to System Restore; and/or if you rarely modify your system. In this case, a regular, unattended backup will provide all the data and system-file security you need, without any of the annoyances of System Restore.
If you're a "tweaker" who frequently modifies or adjusts his or her system; or if you experiment with lots of new software; and if your system is such that the "Simple" option isn't appropriate, then the "Hybrid" option is probably best. Regular backups should still be your main line of defense, but the ad hoc use of System Restore can help correct minor problems that may arise from errant tweaks and software mis-installs.
What's Your Take?
Do you use System Restore? Did you know it was such a space hog? Do you use one of the three approaches outlined above, or do you have another method of ensuring you can restore your system in the even of trouble? What tricks and tools do you use to bulletproof both your data and your system setup? Join in the discussion!
More info on tuning WinXP:
Ten Ways To Make Windows XP Run Better
More info on tuning WinME:
Ten Ways to Make Windows Me Run Better