ard utility stocksjust a little bit before the stock market usually declines.
It’s not often in this life that we are able to get the best of both worlds.But the Williams way to beat Wall Street by design can do exactly that bycombining what we know about the market on a long-term cyclical basiswith what we know about it on a fundamental basis.
From this we also learn that at major stock market lows we want to in-vest in the lowest-priced, highest-yield stocks. Not all market lows come inOctober. You’ll see plenty of other buying opportunities as the markets un-fold over the next 20 to 100 years. But at the low junctures, instead of try-ing  to  buy  yesteryear’s  leaders,  why  not  buy  stable,  solid  blue-chip  typestocks?  These  are  the  safer  ones;  these  are  the  ones  that  are  more  pre-dictable, more precise, and have a lot better chance of staying in business,of weathering the storms.
Utility stocks don’t lead or begin this new bull market; they simply aremore resistant to declines than are industrial or blue-chip stocks. The be-ginning of a bull market ﬁrst lifts up blue-chip and growth stocks. Thesestocks will substantially outperform other issues in the popular market av-erages. So we know the general category of stocks to invest in.
That part of our selection process is pretty simple. The next step is togo to your local library and get Investor’s Business Daily or Value Line todetermine from any list of blue-chip and growth stocks the ones that cur-
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rently  have  the  lowest  prices  and  highest  dividend  yields.  These  are  thesafest, most secure stocks to purchase. Again, others may outperform youon a short-term basis, on the ﬁrst leg of a bull market, that type of thing,but over the long term you will beat the pants off of them. You will dothis  because  they  are  not  consistent  and  they  will  end  up  buying  someturkey  stocks  along  the  way—stocks  that  not  only  don’t  go  up  but  alsohave  substantial  down  moves  despite  the  overall  bull  market.  If  youwanted to make absolutely certain you are buying the best stocks at thejunctures,  you  would  also  check  that  infamous  price-to-sales  ratio  tomake certain that you are buying stocks that have a price-to-sales ratiosbelow 1.0, as we know that the danger of buying high price-to-sales ratiostocks is extreme.
LAZY PERSON’S GUIDE TO BEATING THE FUNDS
Should you decide not to try to pick individual stocks, there is still an easyway to beat the market by beating the funds.
The  concept  is  simple;  since  the  funds  are  not  that  great  themselves,and are always subject to sizable down moves, all we need to do is developa timing system or technique that allows us to buy and sell mutual funds sowe are with them for the up moves and in cash, on the sidelines, when thefunds decline.
This is a most interesting concept—we leave stock picking to supposedexperts! Our effort will be to select funds that advance rapidly in marketup moves, then liquidate our positions before a substantial decline.
We  have  three  challenges  in  this  case.  First,  instead  of  ﬁnding  a  hotstock, we will want to ﬁnd mutual funds that have historically done verywell in market up moves. Second, these funds will charge us no, or a verylow, commission or fee for moving from a long position to cash. Third, wewill need some sort of system or tool to tell us it’s time to lock up our prof-its when trouble in the way of a down move may be just around the corner.There are several rating services of mutual fund performance, but thesad truth is that their ratings have very little to do with a given fund’s fu-ture performance.
Take the hugely successful Morningstar service. If you have ever readadvertisements of the funds you will see them displaying four or ﬁve starsas a sign of a high ranking, a sign of being above average, from the service.These stars as a form of ratings mean nothing! In fact, almost 75 percent of
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188 PUTTING IT ALL TOGETHER FOR LONG-TERM INVESTMENT SUCCESS
the funds Morningstar follows get such four- and ﬁve-star rankings whileonly 25 percent receive the lower one- or two-star rankings.
The plot thickens. Wharton professor Martin Blume recently revealedthat these four- and ﬁve-star rankings can be given to funds that have beenin business for only three years. This is far too short a time to have conﬁ-dence in how a fund will perform. The window is just too tight. Given agood three-year lucky upswing in the market, a new fund will look great,but have no experience in declining markets (or track record to pull downthe hot three years’ performance), as have the older funds, which are not asapt to get the high star ratings.
A recent chart in Investor’s Business Daily, “Leading Funds over theLast  Year,”  illustrates  this  point.  The  yearly  results  are  of  eight  funds  in1994,  a  year  the  stock  market  was  up  1.3  percent.  Of  the  supposed  topfunds, ﬁve of the eight lost money that year!
For 1995 we have another fascinating set of cold, hard facts; the S&P500 was up 37.6 percent. Only one of the eight mutual funds beat the mar-ket. Then along comes 1997, posting a 35.1 percent gain, yet only two ofthe funds did better. Perhaps there’s more, or should I say less, to mutualfund performance than you thought or were told/sold.
Mark  Hulbert’s  Financial  Digest has  been  tracking  the  Morningstarrankings  since  1991  and  ﬂatly  states  that  the  “top  ranked  funds  havelagged the stock market by an average of 3 percent per year!”
Forbes magazine and Value Line also rank funds, and Hulbert’s num-ber crunching arrives at the same conclusion; these rankings have no abil-ity to spot the best funds in the next time period. The bottom line is thatthe  well-ranked  funds  underperformed  the  market  in  the  future,  in  somecases by almost 5 percent a year.
Knowing that even the pros cannot pick the hot funds for the comingyear leads us to ask, “Is it possible to time the funds?” If so, in theory, wecould  miss  the  big  slides  that  hurt  the  funds’  performance  and  we  couldsidestep bear markets.
The answer is a clear-cut: “Yes, you can beat the funds with a simplemechanical rule or two. It is possible to be out of the markets when the bigcrashes come.”
Sure, it will take a little work to time the funds you are holding. It maytake 15 minutes a week at the most, and many weeks there will be nothingto do.
As always, I’ll ﬁrst prove my point, then give you the formula you need
to pull this all off.
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Our  ﬁrst  step  will  be  to  buy  a  mutual  fund.  Which  one?  It  may  notmatter too much, based on the evidence I’ve just presented. The old reli-able  funds  would  include  Kaufman,  Oppenheimer  Quest  A,  AIM  FundsAggressive Growth, Fidelity Low Priced, Fidelity Contrafund, Fidelity Inv.,Destiny l or 2. Most brokerage ﬁrms have funds that have decent perfor-mances as well. What you are looking for is a growth fund that you can getin and out of for no fee (called a load) or a very small fee. Charles Schwab,Dean Witter, and Merrill Lynch all have funds you can throw your moneyat, and we know rankings, ratings, and the like don’t mean much about fu-ture  performance.  Indeed,  the  only  way  we  can  buy  the  best-performingfund of the next time period is . . . to get lucky!
Several funds have “families of funds” that allow you to switch fromtheir growth fund to a less aggressive fund or even a cash equivalent fund.Fidelity is perhaps the best example of this.
After you put your money down, one of two things will happen: Theprice or asset value will go up, or it will go down! The ups we don’t worryabout. We know stock prices, on average, move higher to the tune of about9 percent a year.
The downs are what we have to worry about. In the long run a care-fully  selected  growth-oriented  mutual  fund  will  make  money  for  us.  Theproblem  is  that  in  the  long  run—out  there  someplace—is  a  bear  marketjust waiting to happen that will lop off 20 percent or more of the fund’svalue, seemingly stealing one-ﬁfth of your money.
Our object, our desire, is to beat the funds by having a safety valve oroff  ramp  to  get  us  out  before  such  an  onslaught  of  selling  tramples  thegrowth our investments have made.
As you can tell, I’m a pretty down-to-earth guy. I don’t act on whimsand fancy rumors. I want, need, things documented as fact to stir me to thepoint of shelling out my hard-earned dollars. So should you.
$10,000 TO $8,000,000 TRADING FUNDS
The  leading  advocate  of  mutual  fund  timing  and  switching  is  a  fellownamed  Richard  Fabian.  Dick  has  been  a  fund  trader  for  more  than  aquarter of a century. In that time period he has clearly proven the advan-tages of timing funds, that it can be done. In real time, his advisory ser-vice  and  telephone  hot  line  have  beaten  the  funds.  The  service  can  bereached at 800-950-8765.
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Nelson Freeburg, editor of Formula Research (901-767-1956), did anexhaustive study of the Fabian Formula in 1994 and concluded the “sys-tem  has  outperformed  the  stock  market  going  back  to  1929,  the  resultswere  consistent  across  a  broad  range  of  parameters  . . .  the  method  hasbeen put to test in the real world.”
Freeburg goes on to point out that a strict buy and hold of stocks from1929 forward shows an annual compound gain of 9.2 percent. Had youplunked  down  $10,000  way  back  then  you’d  have  had  $2.94  million  bythe end of 1993.
Using  the  Fabian  Formula  to  time  the  market,  your  $10,000  would
have grown to $8.10 million!Do I have your attention?Good, let me lay this on you: Of the 10 biggest one-day market de-clines since 1929 the Fabian Formula was on the sideline 80 percent ofthe time.
Is our risk limited when we use market timing? Yes, it is. In fact, theformula, according Freeburg carries almost 40 percent less statistical riskthan  the  buy-and-hold  approach.  This  is  pretty  obvious.  If  the  methodworks it should bypass the big declines. Now here’s the interesting point.The signals are just a little over 50 percent accurate, but the average gainhas  been  about  six  times  the  average  loss.  Winners  last  10  times  longerthan losers.
By now you should be clamoring at the bit for the rules, so here they are:
❙ Buy when the fund closes for the week above a 39-week moving av-erage of the fund’s weekly closes, and either the Dow Jones Industri-als or Utilities have also closed above their 39-week average.
❙ Sell, to exit the long position, when the fund’s weekly closing price isbelow the 39-week average, and either the Dow Industrials or Utili-ties have also closed below their 39-week average.
That’s  all  there  is  to  it.  No  other  rules,  as  tested  by  Freeburg,  thoughFabian may have added a few twists in recent years.
You can use the Fabian Formula as given here or an improved varia-tion Freeburg devised. His formula takes that $10,000 from 1929 to $11.7million and with lower statistical risk than the original Fabian model.
The best example of this risk-reducing approach is in the time periodfrom 1929 to 1939. Stocks, as measured by the averages, lost 2.1 percent ayear, while the model you are about to learn showed a proﬁt of 5.3 percent
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a year. Measuring risk by standard deviation, the formula was 31 percentless risky than the market itself.
Now to the rules:
❙ Buy when the Dow 30 index closes 2 percent above the lowest pointof the market decline, and the Dow Transports are 4 percent abovethe lowest point of the market decline, and the Dow Utilities are 8percent above the lowest point of the decline.
❙ Sell, move to cash, and liquidate the fund when the Dow is 2 percentbelow the highest high of the up move at the same time Transportsare 4 percent below and the Utilities 8 percent below.
That’s all there is to it. At any given time you can see if we are in an up-trend, then look for the signal of a 2 percent decline, 4 percent Transportsdip,  and  8  percent  Utility  dip.  When  all  three  averages  have  been  bit  bysuch trend changes it’s time to leave the party.
An important consideration—Since very many market slides hit stocksthe worst on Fridays and Mondays, I encourage you to create your own“week ending” data. By that I mean use the close of the averages on Thurs-day for your signals. If a signal comes on a Thursday close, exit the fundyou  are  in  and  move  to  cash  Friday  morning.  If  no  signal  is  given  on  aThursday, but is on Friday, exit ﬁrst thing Monday morning.
In  fact,  once  you  start  running  the  numbers  you  will  know,  or  canreadily see, what type of closes will trigger a buy or sell and you can takeaction  shortly  before  the  close  of  business  on  Friday.  Yes,  I  realize  thistakes a little more work on your part. But keep in mind that the vast ma-jority of the time, week after week, prices will be trending and there will beno work to be done. Your work or close monitoring will take place only attimes when a trend reversal is close at hand and it will pay to be alert, onyour toes.
A wrap up on the ratios—The best ratio returns are:
13.9%Lowest price-to-salesLowest price-to-book17.1%Lowest price to 1-year forward earnings 19.3%
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12
MONEY MANAGEMENT:THE KEYS TO THE KINGDOM
I have made this letter longer than usual, because I lackthe time to make it short.
—Blaise Pascal
The  creation  of  a  speculator’s  wealth  comes  from  how  he  manages  hismoney,  not  some  magical,  mysterious  system  or  alchemist’s  secret.  Suc-cessful  investing  makes  money;  successful  investing  with  proper  moneymanagement can create immense wealth.
Here it is, the most important chapter in this book, the most importantchapter  in  my  life,  the  most  valuable  thoughts  I  can  transfer  from  me  toyou. I have nothing of more value that I could possibly give you than whatyou are about to learn. This is not an overstatement.
It  is  the  formula  I  have  used  to  take  small  amounts  of  money  like$2,000  to  over  $100,000,  and  $100,000  to  $1,000,000.  Those  were  nothypothetical victories. We are not talking Monday morning quarterback-ing here; we are talking real time, real money, real proﬁts—proﬁts you canspend, proﬁts you can buy all the luxuries of life with.
Until  you  use  a  money  management  approach  you  will  be  a  two-bitspeculator, making some money here, losing some there, but never makinga  big  score.  The  brass  ring  of  commodity  trading  will  always  be  out  ofyour grasp as you sashay from one trade to another, picking up dollars butnot amassing wealth.
The truly shocking thing about money management is how few people
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want to learn about it or to know the correct formulas. Invariably, when Iam at a dinner or cocktail party the conversation turns to the markets. Peo-ple want hot tips, or to know how I’ve been able to make a living withoutworking. They want my secret. As if there is one!
The public or noneducated speculator thinks there is magic to trading,that  somewhere,  someplace,  someone  has  a  magic  decoder  ring  that  cor-rectly signals market action.
Nothing could be further from the truth. Money is made in this busi-ness  by  getting  an  advantage  in  the  game,  working  that  advantage  on  aconsistent  basis,  and  coupling  this  with  a  consistent  approach  to  howmuch of your bankroll you have behind each trade.
MOST TRADERS USE A HIT-OR-MISS APPROACH
The problem most investors have is that if we are conﬁdent enough to risklarge sums of money, at least large for us, we are also conﬁdent enough tothink we can ﬁgure out the future. That translates into two problem areas.First, we think we can select the winning trades from the losers in oursystem  or  approach.  Worse,  though,  is  when,  believing  we  are  smartenough to do that, we then trade an unequal number of contracts or shareson our various trades.
Just as we must consistently follow our battle plan to succeed, we mustalso be consistent in the amount of money we martial behind each trade.The instant you get the fancy notion you can “for sure” pick the big win-ners and back those trades with larger positions than you have been trad-ing, trouble will ﬁnd you.
Granted,  every  now  and  then  you  will  hit  it  right  and  score  big,  buteventually you will have a loss when you have on that large position. Theloss is bad enough, but since you have overstepped good money manage-ment, you will then become emotional and probably hold onto the tradetoo  long  in  hopes  of  recouping  the  big  hit.  Thus  things  don’t  get  better,they get worse!
Let me turn to our well-worn Las Vegas casino analogy one more time.Casinos all over the world limit their losses by having a maximum amountthe player can bet on any one decision in every game. They, like a good in-vestor should, limit their losses. Can you imagine a pit boss suddenly al-lowing a high roller to bet more than the house limit because the boss feelsthe customer is going to lose on the next roll? Of course not; the pit boss
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would be ﬁred on the spot for breaking a cardinal rule of money manage-ment, betting too much.
Trading too much, betting too much will cost you far more than badmarket  calls.  Remember  we  control  risk  by  limiting  exposure  to  ourbank roll.
APPROACHES TO MONEY MANAGEMENT: ONE IS RIGHT FOR YOU
There are various ways to go about this problem, many formulas to follow.But  all  the  superior  systems  to  manage  your  investment  dollars  have  acommon tenet: You will increase the number of units, contracts, or sharesas you make money and decrease as you lose money. That is the essence ofthe sweet science of the correct marshalling of your funds. This basic truthcan be worked on several ways.
I’m going to show you the major ones in hopes you ﬁnd the shoe thatﬁts you. No discussion on the subject could be complete if the name RalphVince is not brought up. In 1986 I ran across a money management for-mula for playing blackjack originally developed in a 1956 paper, “A NewInterpretation of Information Data,” regarding ﬂow of information, nowcalled the “Kelly formula” by commodity traders.
What I know about math you could add up with your thumb and ﬁrstﬁnger, but I know math works, so I began trading commodities using theKelly formula. Here it is with F representing the amount of your accountyou will back every trade with:
F = (R + 1) × P – 1
R
where P = Percentage accuracy of the system winningR = Ratio of winning trade to losing trade
Let’s  look  at  an  example  using  a  system  that  is  65  percent  accuratewith wins 1.3 times the size of losses. The math is done as follows using Pas .65 and R as 1.3:
(1.3 + 1) × .65 – 1 
= F
1.3
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2.3 × .65 = 1.495 – 1 = 0.495 
1.3
= 38% of account used to trade
In this example you would use 38 percent of your money behind everytrade. If you had a $100,000 account you would use $38,000 and dividethat by margin to arrive at the number of contracts. If margin was $2,000you would be trading 19 contracts.
THE GOOD, THE BAD, AND THE UGLY OF MONEY MANAGEMENT
What this formula did for my trading results was phenomenal. In a veryshort time I became a real-life legend as very small amounts of money sky-rocketed. Using the percent of the money in the account based on the Kellyformula, divided by margin, was my approach. It was so good that I wasactually kicked out of one trading contest because the promoter believedthe results could not be accomplished without cheating! To this day, peopleon the Internet claim I used two accounts, one for winning trades and onefor  losers!  They  seem  to  forget,  or  not  know,  that  in  addition  to  such  apractice  being  highly  illegal,  all  trades  must  have  an  account  number  onthem before the trade is entered, so how could the broker, or myself, knowwhich trade should have the winning account number on it?
But  what  would  you  expect  when  no  one,  to  my  knowledge,  hadturned in that type of performance ever before in the history of trading? Tomake matters worse, I did it more than once. If it wasn’t a ﬂuke or luck.The losers lament is that it must have been done by pinching some num-bers or trades along the way.
What I was doing was revolutionary. And, like with any good revolu-tion, some blood ﬂowed in the streets. The blood of disbelief was that ﬁrstthe  National  Futures  Association  and  the  Commodity  Futures  TradingCommission commandeered all my account records, looking for fraud!
The  CFTC  went  through  the  brokerage  ﬁrm’s  records  with  a  ﬁne-toothed comb, then took all my records and kept them for over a year be-fore giving them back. About a year after getting them back, guess what,they wanted them back again. Success kills.
All this was due to market performance that was unheard-of. One ofthe accounts I managed went from $60,000 to some $500,000 in about18  months  using  this  new  form  of  money  management.  Then  the  client
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sued me, her lawyer, saying she should have made $54,000,000 instead ofhalf a million. Now my believers were willing to put me on a pedestal, ifthey  could  collect  some  money.  The  revolution  was  more  than  anyonecould handle.
What a story, huh?But there are two edges to this money management sword.My extraordinary performance attracted lots of money for me to man-age. Lots of money, and then it began to happen . . . the other side of thesword ﬂashed in the sun. Amidst trying to now be a business manager (i.e.,running  a  money  management  ﬁrm),  with  precious  few  skills  at  doingsomething I’m no good at anyway, my market system or approach hit theskids, encountering a cold streak that saw equally spectacular erosions ofequity. While I had been making money hand over ﬁst, I was now losingmoney hand over ﬁst.
Brokers and clients screamed. Most took the off-ramps—they simplycould not handle this type of volatility in their account balances. My ownaccount,  which  had  started  the  ﬁrst  of  the  year  at  $10,000  (yes,  that  is$10,000) and reached $2,100,000 (yes, that’s $2.1 million) got hit alongwith everyone else’s. It too was caught in the whirlpool, spiraling down toa meager $700,000.
About then everyone jumped ship, except me. Hey, I’m a commoditytrader; I like roller coasters. Is there another form of life? Not that I knew,so I stayed on trading the account back to $1,100,000 by the end of 1987.
What a year!Watching all this over my shoulder every day was Ralph Vince, whilewe were working together on systems and money management. Long be-fore I could see it, he saw it, saw there was a fatal ﬂaw in the Kelly for-mula. I was too dumb. I kept trading it while Ralph, being the math geniushe is, began intense research into money management, the culmination ofwhich  are  three  great  books.  His  ﬁrst  was  The  Mathematics  of  MoneyManagement,  followed  by  Portfolio  Management  Formulas,  and  my  fa-vorite, The New Money Management, all published by John Wiley & Sons,Inc. These are must-reads for any serious trader or money manager.
Ralph noticed the error of Kelly, that it was originally formulated toassist in implementing the ﬂow of electricity, then used for blackjack. Therub comes from the simple fact that blackjack is not commodity or stocktrading.  In  blackjack  your  potential  loss  on  each  wager  is  limited  to  thechips you put up, while your potential gain will always be the same in rela-tion to the chips bet.
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We speculators don’t have such an easy life. The size of our wins andlosses bounces all over the place. Sometimes we get big winners, sometimesminuscule ones. Our losses reﬂect the same pattern; they are random in size.Now the reality is that this system may not hold up in the future ex-actly  like  this.  You  will  probably  not  want  to  trade  up  to  5,000  bonds,which  this  test  allowed.  In  that  case  one  tick,  the  smallest  price  changebonds can have, would cost you $162,500 if that one tick is against you.I’ve  been  there  . . .  that’s  real  pressure.  Let  me  add,  it  is  not  unusual  forbonds to open 8 to 10 ticks against you. Every morning, that’s $1,625,000!So, don’t get carried away with the proﬁts. Focus on the impact of the re-sults money management can produce.
As soon as Ralph realized this, he could explain the wild gyrations inmy equity swings, that they came about because we were using the wrongformula. This may seem pretty basic as we have a new century, but backthen we were in the midst of a revolution in money management and thisstuff was not easy to see. We were tracking and trading where, to the bestof my knowledge, no one had gone before. What we saw were some phe-nomenal trading results, so we did not want to wander too far from what-ever it was we were doing.
Ralph came up with an idea he calls Optimal F. It’s similar to Kelly, butunlike