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destroy your nest egg. Conversely, investments always viewed as more speculative, such as common stoclcs, have become outstanding vehicles to protect and enhance your capital.

Yes, all the prudent rules of saving we learned at our fathers Icnees are out the window. Since the Second World War there has been a revolution every bit as violent to the old order of investing as the French Revolution was to the old order of Europe.

Revolution does not have to mean the destruction of your savings. As the Industrial Revolution shifted fortunes from the titled nobility to entrepreneurs, as the railroad revolution enriched the Vanderbilts and Goulds, as the information revolution enriched the Gateses and Jobses, so this investment revolution, if you Icnow what causes the changing structure, can enrich you. In each of these revolutions, the odds strongly favored those who found the new road and disfavored those stuclc in the same old path.

This book is about odds or probabilities in markets, and how to use them to your advantage. There are probabilities of success or failure in the marketplace as surely as in gambling, business, or warfare.

Napoleon was the greatest probability player of modern warfare. Most often outnumbered, he won by moving fast and concentrating his forces on the battlefield on the enemys weak points. Yes, there was brilliance in his strategies, but a good part of his military genius lay in his knowledge of the odds in any situation. On the first Italian campaign, for instance, he gambled on the perilous dash through Genoese territory rather than throw his ragged, demoralized men against the fortified Alpine passes, and was able to defeat the numerically superior but divided Austrians by keeping his forces unified. While poised precariously before the gates of Vienna, however, he gave the Viennese a generous treaty rather than take a chance on being cut off from his supplies.

The story is told of Napoleon playing cards with his generals and staff to pass the time en route to Egypt with his invasion fleet. He heard one of his aides whispering in the background and asked him to speak up. The aide, fearing for his life, stammered, "I said, General, you are not playing fairly." Napoleon said, "Thats true, but I always give the money back at the end of the game."

General Murat, who was to become one of his legendary Marshals, spoke up with trepidation, though he had always been fearless in battle. "General, if I may be so bold, can I ask a question? " Napoleon nodded and he continued, "If you give the money back, why then do you cheat?" Napoleon replied, "Because I want to leave nothing to chance."

"Interesting story," you might say, "but how does it apply to the marketplace?" Believe it or not, despite appearances, the market does not

Great Expectations

Professional investors manage large pools of money for mutual funds, pension funds, bank trust departments, money management firms, insurance companies, and similar financial institutions. The assets under their management are growing phenomenally, su assing $14.8 trillion

ran on chance or luck. Like the battlefield, it rans on probabilities and odds. These control markets every bit as strongly as they do roulette, blackjack, craps, or any other game in a casino. Unlike Napoleon at cards, we dont have to cheat, though our survival does depend on staying ahead of the opposition. As this book will show you, the odds in the marketplace can be turned decisively in your favor.

What is behind the probabilities in markets? Is it a new system to divine the future, or differential equations critical to the development of physics and now used extensively in economics? Millions of dollars worth of the best research money can buy? No. Our probabilities are not built on any of these techniques or on foreseeing the direction of markets, or on any other conventional approach. Rather they are embedded in investor behavior in the marketplace.

I know it sounds strange. "Psychology," some people might snicker, "is the last place in the world to find any sort of reliable odds." Its true all the same. Betting on well-defined patterns of investor behavior will give you higher probabilities-strongly backed by statistics-than any other method of investing in use today. These are the odds available in the green wing of my imaginary casino. But how do you arrive at them?

That is what this book will try to show you. But the last thing I want to do is ask you to take my advice or anybody elses on faith. Too many systems and faith healers already clutter the marketplace. None that I know of do what they claim-beat the market. And most cost. We will carefully look at the odds of which investment methods work and which dont, forgetting the popularity of one technique or another.

To start, well look at the two methods heavily favored by knowledgeable investors: the use of professional money managers and the efficient market hypothesis. The first relies on the "edge" the professional investor can give you by banking on his or her knowledge, skill, and experience to tum the odds in your favor. Do these professionals understand the new market dynamics that I have discussed briefly? Do they win big in this dramatically changed environment? To find out, lets look at the expert record.

by the end of 1997, and expanding faster than the GDP (gross domestic product). They control over 70% of the trading and 50% of the stock holdings on the New York Stock Exchange. Their buying power staggers the imagination. By 1997 they were estimated to be buying and selling $2 trillion of stocks annually, generating $10 billion of commissions in the process. They claim the crown as the elite of their profession.

The professional money manager is believed to bring a new depth of knowledge to securities markets. Armed with the best research money can buy, and legions of well-trained, battle-hardened colleagues, they were said to have turned the odds decisively in their favor. The change was welcomed by knowledgeable observers of the financial scene. They urged the uninformed and emotional small investor to realize that he was ill equipped to deal with the complex modem market and to tum his money over to one of these seasoned pros. Some writers on the subject have gone so far as to state that the average investor is "obsolete" today. So, with some knowledge of the role these professionals play in the nations finances, we should now ask whether they have indeed brought die Age of Camelot to markets.

Unfortunately, in a word the answer is no. The great majority of money managers have consistently lagged behind the market averages. John Bogle, chairman of the Vanguard Group, one of the largest mutual fund organizations in the country, stated that 90% of money managers unde erformed the market in every ten-year period since their performance began to be measured in the early sixties. Burton Malkiel, a professor of finance at Princeton and author of the widely read A Random Walk Down Wall Street, studied all domestic equity mutual funds and found that they unde erformed their market benchmarks from 1971 to 1991 Information taken from Momingstar and Lipper Analytical Services, two of the largest services tracking the performance of mutual funds, measured the results for 3-, 5-, and 10-year periods to the third quarter of 1997 for the six major classes of stock funds. The results appear in Figure 1-1. As you can see, the market (as measured by the S&P 500) outperformed all categories of mutual funds for all periods (the one exception was small companies, which provided nominally better retums for five years). Numerous studies by pension-fund consultants, who monitor the results of hundreds, and in some cases thousands, of money managers, have come up with similar findings.

What conclusions can we draw from the tepid performance of professional investors? The rational and unemotional professional, according to financial lore, coolly gauges value and buys securities at bargain

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