This week we look at how to make you a top 20% investor, think about some of the mistakes we all make and much more. I am writing today in Florida and will finish up in Texas tonight before taking off for Philadelphia. Because of the time constraint on my usual research, I am going to borrow a few pages from Bull's Eye Investing and some letters written last year and add a few thoughts. I think this letter contains some very important points that are worth repeating. If you would like more on this line, you can go to chapters 15 and 17 in Bull's Eye Investing (see below how to get a 32% discount.)

I should note that I have just finished a new (free) Accredited Investor E-letter which will be sent out within a few weeks. It has been some time since I have written one, but I am now committed to getting one a month out. I apologize to those who have signed up for the letter and have not gotten one for months. No more apologies, just copy will be my future motto.

For those who are interested and who qualify, I write a free letter on hedge funds and private offerings called the Accredited Investor E-letter. You must be an accredited investor (broadly defined as a net worth of $1,000,000 or $200,000 annual income - see details at the website.) You can go to www.accreditedinvestor.ws to subscribe to the letter and see complete details, including the risks in hedge funds. (In this regard, I am registered representative of Millennium Wave Securities, an NASD member firm. See more disclosures on the web site and at the end of this letter.)

Why Investors Fail: Analyzing Risk

Like all the children from Lake Wobegon, my readers, I am sure, are all above average. But I am also sure you have friends who are not, so in this chapter we look at the reasons why they fail at investing, and how they should analyze funds and determine risk. Hopefully this will give you some ways to help them. I will show you a simple way to put yourself in the top 20 percent of investors. This should make it easier to go to family reunions and listen to your brother-in-law's stories.

A key part of successful Bull's Eye Investing is simply avoiding the mistakes that the majority of investors make. I can give you all the techniques, trading tips, fund recommendations, forecasts, and so on, but you must still keep away from the patterns that are typical of failed investors.

What I want to do in this chapter is give you an "aha!" moment: that insight which helps you understand a part of the mysteries of the marketplace. We look at a number of seemingly random ideas and concepts, and then see what conclusions we can draw. Let's jump in.

Investors Behaving Badly

The Financial Research Corporation (FRC) released a study in 1999 prior to the bear market, which showed that the average mutual fund's three-year return was 10.92 percent, while the average investor in those same periods gained only 8.7 percent. The reason was simple: Investors were chasing the hot sectors and funds.

If you study just the past three years, my guess is those numbers will be worse. According to Jeffrey A. Dunham,

"The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.

"Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their "best performing" quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter." (Dunham & Associates Insight, 1st Quarter 2002, http://www.dunham.com)"

I have seen numerous studies similar to the one cited. They all show the same thing: that the average investor does not get average performance. Many studies show statistics that are much worse.

The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (U.S.) stock equity mutual funds. (I will comment on why I believe this is so later on.)

The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:

1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5 to 10 percent returns during one decade, 10 to 20 percent during the next decade, and then slip to the 0 to 5 percent range.

2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. Number 1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e., #1 vs. top decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half.

This is in line with the study cited earlier in Chapter 8 from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.

The chance of you picking a stock today that will be in the top 25 percent of all companies every year for the next 10 years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for extended periods of time is an extremely difficult feat.

Yet what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25 percent a year for five years that it will do so for the next five. The actual results for the past 50 years show the likelihood of that happening to be small.

Why Investors Fail

While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as he switches from his poorly performing fund to the latest hot fund just as it turns down.

Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know. He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their ideas have investment merit.

He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern recognition software available. They have run price data through every conceivable program and come away with this conclusion:

Past performance is not indicative of future results.

Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.

Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonald's that coffee is hot. We don't pay attention.

Chasing the latest hot fund usually means you get into a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.

What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis into their systems.

This is consistent with work done by Dr. Gary Hirst, one of my favorite analysts and fund managers. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him as to the results of his research:

"I had heard about technical analysis and chart patterns, and looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out, and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools--stochastics, RSI, chart patterns, Elliott Wave, and so on--just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact, almost all technical analysis can be reduced to this one thing, though most people don't realize it: The distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure, I found things that work over the short term, systems that work for five or ten years but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."

I've Got a Secret System

If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy software packages that will show you how to day trade and make 1,000 percent a year. For $5,000 you can buy an "exclusive" letter (just you and a thousand other readers, and their friends and clients) that will give you a hot options or stock tip. You will be shown winning trades that make 100 percent or more in a short time. You, too, can use this simple tested method to enrich yourself. Act now. (Add $6.95 for shipping and handling.)

Full disclosure here: I am a manager of investment managers. I look for investment managers and funds for clients. Most of the funds I look at are in the private fund or hedge fund world. I get to see the track records and talk with some of the creme de la creme of the investment universe -- the true Masters of the Universe. These are the managers available only to accredited investors ($1,000,000 or more net worth). This world is growing by leaps and bounds as more and more sophisticated investors and institutions are looking at these managers now that mutual funds and stock managers are having bad years.

None--not one--nada--zippo--zero of the best managers in the world can deliver the consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30 percent a year. You can't get into it. But in 2001 and 2002 it was flat.

Steve Cohen can deliver some spectacular returns and has for almost 20 years. His funds been closed to new money for years. But even this legend can't put up numbers like I see in the ads.

Here's the reality. If you could make 20 percent a year steady, in five years--ten at the most--you would be managing all the money you could run. Trust me, the money will find you. You will charge a 2 percent management fee and keep 20 percent of the profits. On $1 billion, that amounts to $60 million in fees. That's every year, of course. Why would you sell a system that could do 20 percent a year?

Once everyone knows about a system, it won't work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their runs. Every dog has its day in the sun. The trick is to figure out when the sun is setting.

When Will the Next Bull (or Bear) Market Run Begin?

First, let me make this very clear: There is no technical indicator, or even fundamental system, that can tell us when the next bear market rally will begin or end, or when the bear market will be over and a new bull will begin. All of this talk on TV or in newsletters about this indicator or that system telling us we are at the exact top or bottom is just voodoo investing. It is an exercise in wishful thinking.

The Nobel Prize in economics in 2002 went to a psychologist, Dr. Daniel Kahneman, who helped pioneer the field of behavioral finance. If I can crudely summarize his brilliant work, he basically shows that investors are irrational. But what gets him a Nobel is he shows that we are predictably irrational. We continue to make the same mistakes over and over. One of the biggest is our common inability to take a loss. He goes into long and magnificent explanations of why this is, but the bottom line is that taking a loss is so painful, we simply avoid it.

While technical indicators cannot be rigorously programmed to yield an automatic, always winning or low loss, don't-think-about-it trading system, they do provide some useful insight. Volume, direction, momentum, stochastics, and so on are reflective of market psychology. With a great deal of time and effort, astute traders can use this data to determine what Mark Finn calls the "gist" of the market.

The great traders become adept at using this data to help them determine market psychology and thus market movement. They also employ excellent money management and risk control skills. My contention is they have the "feel." Just like some people can hit 95 mph fastballs, they can look at amazing amounts of data and feel the market. They use solid money management techniques to control the risk, and they make money for themselves and their clients. Like Alex Rodriguez at the plate, they make it look easy.

And thus many ordinary people think they can do it. And most fail.

For some reason, we take this failure personally. It seems so easy, we should be able to do it. But after years of interviewing hundreds of managers and looking at thousands of funds and mounds of data, I have come to believe it is a gift, just like hitting baseballs or golf balls.

If it were easy, everybody could do it. But it's not, so don't beat yourself up if you are not the one with the gift. It would be like me getting angry at myself for not being a scratch golfer. It is not going to happen in my lifetime. It does not matter how much I practice. I simply don't have the talent to be a scratch golfer. If I wanted to bet on golf, I would bet on a pro, not on me.

Becoming a Top 20 Percent Investor

Over very long periods of time, the average stock portfolio will grow at about 7 percent a year, which is GDP growth plus dividends plus inflation. This is logical when you think about it. How could all the companies in the country grow faster than the total economy? Some companies will grow faster than others, of course, but the average will be 7 percent. There are numerous studies that demonstrate this. That means roughly 50 percent of the companies will outperform the average and 50 percent will lag.

The same is true for investors. By definition, 50 percent of you will achieve the average; 10 percent of you will do really well; and 1 percent will get rich through investing. You will be the lucky ones who find Microsoft in 1982. You will tell yourself it was your ability. Most of us assign our good fortune to native skill and our losses to bad luck.

But we all try to be in the top 10 percent. Oh, how we try. The FRC study cited at the beginning of this chapter shows how most of us look for success, and then get in, only to have gotten in at the top. In fact, trying to be in the top 10 percent or 20 percent is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up.

Here is the very sad truth. The majority of investors in the top 10 to 20 percent in any given period are simply lucky. They have come up with heads five times in a row. Their ship came in. There are some good investors who actually do it with sweat and work, but they are not the majority. Want to make someone angry? Tell a manager that his (or her) fabulous track record appears to be random luck or that they simply caught a wave and rode it. Then duck.

By the way, is it luck or skill when an individual goes to work for a start-up company and is given stock in a 401(k) that grows at 10,000 percent? How many individuals work for companies where that didn't happen, or their stock options blew up (Enron)? I happen to lean toward grace, rather than luck or skill, as an explanation, but this is not a theological treatise.

Most millionaires make their money in business and/or by saving lots of money and living frugally. Very few make it by simply investing skill alone. Odds are that you will not be that person.

But I can tell you how to get in the top 20 percent of investors. Or better, I will let FRC tell you, because they do it so well:

For those who are not satisfied with simply beating the average over any given period, consider this: If an investor can consistently achieve slightly better than average returns each year over a 10-15-year period, then cumulatively over the full period they are likely to do better than roughly 80 percent or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one- or three-year period. That "failure," however, is more than offset by their having avoided options that dramatically underperformed. Avoiding short-term underperformance is the key to long-term out-performance.

For those that are looking to find a new method of discerning the top 10 funds for 2002, this study will prove frustrating. There are no magic shortcut solutions, and we urge our readers to abandon the illusive and ultimately counterproductive search for them. For those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this approach to compound into something much better.

That's it. You simply have to be only slightly better than average each year to be in the top 20 percent at the end of the race. It is a whole lot easier to figure out how to do that than chase the top 10 funds.

Of course, you could get lucky (or blessed) and get one of the top 10 funds. But recognize it for what it is and thank God (or your luck if you are agnostic) for His blessings.

I should point out that it takes a lot of work to be in the top 50 percent consistently. But it can be done. I don't see it as much as I would like, but I do see it.

Investing in a stock or a fund should not be like going to Vegas. When you put money with a manager or a fund, you should think as if you are investing in their management company. Ask yourself, "Is this someone I want to be in business with? Do I want him running my company? Does this company have a reasonable business objective? What is its edge that makes me think it will be above average? What is the reason I would think this manager could discern the difference between randomness and good management?"

When I meet a manager and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When managers tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it.

It is not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund for the year, that is random. It had a good run or a good idea and it worked. Is it likely to repeat? No.

But being in the top 50 percent every year for 10 years? That is not random. That is skill. That type of consistent solid management is what you should be looking for.

By the way, I mentioned at the beginning of this chapter that past performance was statistically useful for ascertaining relative performance of certain types of funds like bond funds and international funds. In the fixed income markets (bonds) everyone is dealing with the same instruments. Funds with lower overhead and skilled traders who aggressively watch their trading costs have an edge. That management skill shows up in consistently above-average relative returns.

Likewise, funds that do well in emerging market investments tend to stay in the top brackets. That is because the skill set and learning cost for international fund management is rare. In that world, local knowledge of the markets clearly adds value.

But in the U.S. stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. If a fund does well in one year, it is possibly because its managers took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row. Plus, the U.S. stock market is cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.

Philly, London, Bermuda

If you would like your own copy of Bull'sEye investing you can go to Amazon and get a 32% discount. www.amazon.com/bullseye

That is enough for this week. I am writing this letter a little early this week, as on Thursday I am going to Philadelphia to meet with good friend Steve Blumenthal and his partners at Capital Management Group. Jon Sundt of Altegris is going to join us. It's strictly business, except for the golf on Friday morning at Stonewall. Evidently quite the fancy course. Caddies and everything. Pity that I can't bring a decent golf game, but spending the time to get a low handicap might mean my research would fall off. At least that's my excuse for now.

Driving around Orlando, I am amazed at the destruction of Hurricane Charlie. It must have been terrible to be on the coast in the direct path. My heart goes out to all those who have lost so much. I have also seen reports that this may be one of the busiest hurricane seasons in decades. The Red Cross will be busy. Maybe those of us in the rest of the states should think about sending the Red Cross some money so they will be able to deal with the next disaster which may be in our own back yards.

Your thankful for all his blessings analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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