The term for this in the investment community is macro analysis, a top-down approach to investing

Solution to Mistake #1: Use the Right Strategy

THE FIRST THING YOU MUST DO TO BE A WINNER IN THE STOCK market is to develop a sound investing strategy, one that you can stick with because, among other things, you believe in its principles.

Since 60 percent of all stock price movements are related to the trend of the overall market, the right strategy must be one that begins at the top and works down. You must know what the risk/reward is at all times for successful investing. To do this, you must be brutally honest with yourself.

I visit many money managers around the country, and I am amazed by how much paper they have on their desks. How in the world can they process all this input? The reality is that most cannot. The human mind can handle only so much data at one time. Nobel laureate Herbert Simon said, Millions of new bits of information hit our environment every second.

There are two types of reasoning processes we use to function in life. One is linear, in which our thoughts travel from one point to another in a logical sequence similar to building a home from a set of blueprints within a given timeline. The other type of reasoning is interactive. This is more complex, whereby each separate piece of information used in reaching a decision affects the other pieces and may not even be available at the same time. For example, if we plan to start a business, we have to know if there is a demand for our product and what the costs will be to make it, taking into account the availability of qualified workers, the anticipated revenues, and the current and future trends of the economy. All of these variables, and more, must be considered if we are to be successful.

Many people are very good at interactive reasoning. If you are one of those people who can multitask, you would be good at interactive reasoning. However, while these talents would be useful in many business situations, they are useless in the stock market. Each piece of information required to make money in the market interacts with all the other pieces. Some of these elements include: the current Federal Reserve policy and its impact on interest rates, political events, foreign affairs, war, oil shortages, terrorism, and the trend of the economy where you live. All of these events affect the stock market in some way. The problem is that most of them are out of your control.

Further proof that interactive reasoning is ill suited for the type of analysis required to be successful in the stock market is the record of market experts. In the past 51 years, more than 50 surveys have been made by experts forecasting their favorite stocks and industries. Expert selections underperformed the stock market 75 percent of the time!

When I managed a large stock brokerage office in Boston, I used to tell the brokers that they could not control the market. The only thing they could control was their work habits. The reality is that the human mind, or even a computer for that matter, cannot process all the information that is coming from the market, and how each piece relates to other pieces. Our minds, in effect, lead us to failure in the stock market.

Since the stock market requires a certain type of reasoning that is impossible for our minds to utilize, you could say we were born to lose in the stock market. There is a solution, however. Knowing that we have no chance, we have to ask ourselves if the market letter writers and the financial media know they are destined to be wrong as well. They do not; it is only their job to advise and appear as experts.

Our brains must use interactive reasoning to process all the information that affects stock prices and market trends. We cannot do it all and we know it. On the other hand, market experts such as those seen on television and the hundreds of market letter writers who influence public opinion do not know they are doomed to failure.

So the first part of our strategy is to not follow experts. Then, once we have determined what the majority of these experts are saying, we can safely do the opposite!

I began my investment career in 1966 as a stockbroker with E.F. Hutton. As a new broker, I was encouraged to use the firms recommended list to pick stocks for my clients. It did not take long for me to become disillusioned. It seemed to me that at the bottom of every bear market, the entire recommended list was on the new low list! I knew I would become an ex-stockbroker soon unless I found a better way to make money other than to use the system offered by the firms research analysts.

Beginning in 1972, I started plotting charts of the stocks in Huttons recommended list. I focused my attention on those stocks the firm liked that were already in up-trends. This helped considerably for a few years. However, the bear market of 1973-1974 destroyed that theory. Charting stocks was useful in picking stocks, but it failed to help me with the big economic picture. The term for this in the investment community is macro analysis, a top-down approach to investing. Macro analysis assumes that if you are correct on the trend of the economy, and the overall trend of the stock market, you can take positions when the time is most favorable and avoid the stock market at other times. This made a lot of sense to me, but I was clueless as to how to do it.

I told you earlier that 60 percent of an individual stocks price movement is related to the overall trend of the market. After all, the major macro players on Wall Street were also experts and I knew that macro analysis also used interactive reasoning, which did not work. Therefore, I could not trust the macro experts, either. It seemed there was nowhere to turn and I was doomed to investment mediocrity.

I have always felt providentially guided. It seemed whenever I needed an answer to a life problem, it turned up. This time it came to me in an article I read about the history of Vilfredo Pareto.

Vilfredo Federico Damaso Pareto was a nineteenth-century Italian economist who observed that a large percent of the national wealth in Italy was held by a small number of people. Pareto found that 80 percent of the land in Rome was owned by 20 percent of the population. Even as a gardener, he observed that 80 percent of the peas were harvested from 20 percent of the peapods. In modern times, the same concept exists in business, and in many other places as well. Most business managers will tell you that 80 percent of the sales and profits are generated by 20 percent of the people in their company, while at the same time 80 percent of a companys problems are caused by 20 percent of their employees.

Pareto himself could not have predicted that this simple ratio would be applied and restated thousands of times in boardrooms and business offices around the world, with managers referring to it as the Pareto Principle, the 80:20 Rule, and The Vital Few and The Trivial Many Rule. I had never seen anyone apply Paretos ratio to the stock market, but I reasoned that since it worked so well in business, it could be very valuable in analyzing the stock market.

My father used to tell me it is alright to be average or below average at something, but do not be unaware of it. Once I had inferred that success in the stock market required a certain type of reasoning that was impossible for the human mind to utilize, I had to admit I was a loser in the stock market, and it would logically follow that everyone who followed my advice would also be a loser. I also knew that there were experts out there who could not or would not admit they were losers, too. These experts and the millions of investors they influenced were The Trivial Many. It was this group that I would bet against in the future. At important turning points, I knew they had to be wrong; otherwise Paretos principles were invalid. Logic told me Vilfredo Pareto had made an important human nature observation, and my new investment strategy was beginning to take shape.

I had identified who The Trivial Many were. To complete my strategy, I only had to find out who were The Vital Few. That is when my guardian angel came to my rescue again. I was living in Fort Lauderdale, Florida, and had just left E.F. Hutton for Dean Witter. One of the brokers in the office invited me to a local stock and bond club meeting. The formal meeting was preceded by a cocktail hour. During the party, I noticed a small middle-aged man wearing a bow tie. He looked somewhat out of place, but he had sort of a wry smile on his face, as if he knew a valuable secret. Approaching him, I introduced myself, and he told me his name was Perry Wysong. We exchanged pleasantries and in a short time began talking about the stock market.

I was amazed to find that Perry ran a small private fund of $25 million. He told me he was averaging 25 percent a year. He did not look like the type of person who would play one-upmanship, so I asked him to explain his methodology. He told me he followed corporate insiders.

Instantly, a bell rang in my head. Who knew better what was going on in companies than the officers and directors? It made perfect sense. Perry went on to explain that many university studies show that insiders outperform the stock market by a wide margin, consistently over time. The minute he explained how he did it, I was hooked. I had found The Vital Few!

That was in 1977. Over the next five years, Perry and I would meet for lunch and talk primarily about insiders. He loved the concept, and I was rapidly becoming one of his disciples. I told him I wanted to develop my own strategy for following insiders. He told me he would be happy to help me become successful. Perry was my friend and idol until the day he died, and I have always been grateful for his generosity.

With Perrys help, I began using my new investment strategy. I would use stocks bought by insiders when market conditions were favorable. A favorable market condition was when letter writers and experts were negative and insiders were positive. For the first time in my life, my clients were consistently making money. Many told me they had never been out of the stock market prior to a broad decline. They relished buying against the grain of public opinion when stocks were deeply depressed.

From 1978 to 1986, I hosted my own television show in South Florida called The Muzea Insider Report. I became known in Fort

Lauderdale as Mr. Insider. Not only was I making a lot of money for my clients, I was truly enjoying myself. I retired from the brokerage business in 1986 at the age of 47. By then I was able to live off my principal gains and continued to utilize my investment strategy on my own.

Let us stop for a moment here and review what I have told you so far.

Everyone needs an investment strategy or style that is easy

to follow and produces consistent profits.

The only way to consistently make money in the stock mar

ket is to go against the grain of public opinion. The Pareto Principle works. Going against the 80 percent (public) and with the 20 percent (insiders) is the answer.

Since the key to this strategy is to invest in the stock market

only when the Vital Few are buying and The Trivial Many are selling, it is obvious that you must be willing to stay out of the stock market for long periods of time. Only losers bet on every horse race. It is the same with stocks.

In subsequent chapters, I spell out my entire strategy on becoming a consistent winner in the stock market, but first we need to go over the second and third mistakes made by most investors.