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True story: I'm portfolio manager of an account up over 130% since early 2000. This in sharp contrast to a stock market -- down around 50% over the same time frame. I told a friend about this massive, spectacular performance, who in turn promptly asked, "Can you manage my portfolio?"

When Past Performance Speaks, Investors Listen

And why not? I must be better than other investors, who are down across the board these last few years. Let me give you the details of my 5-star performance -- details you would never be privy to for mutual funds you consider -- and you can decide if forking over your money is such a great idea.

This very small brokerage account was set up in 2000, ignored and left in cash for about a year (back when cash had a yield). After a year or so I switched most of the money into a global bond mutual fund, which has done quite nicely. I completely forgot about the portfolio again.

On March 13 I had an idea. I thought

American Airlines

parent company



wasn't going bankrupt and felt management was playing possum just to get concessions with labor unions and government handouts.

This was not a well-thought-out plan -- I have no experience analyzing airline stocks and spent zero time reviewing the financials of the world's biggest airline. Still, I wanted to put my conspiracy theory into play and remembered the long-forgotten account.

I raced online and sold all my shares in the global bond fund -- at a nice gain of more than 10% from when I purchased it. I immediately tried to buy AMR stock but couldn't -- some sort of settlement issues I suppose, as there was no other cash in the portfolio. A friend called, I got sidetracked and forgot the whole scheme for the time being.

On March 30 I read some more news about AMR and how bad things were for airline travel due to the war, and remembered the whole plan. I went online and put almost the entire account into AMR shares at $1.75. The stock ran up a day later, only to fall to lower prices. I sat tight.

Over the weekend American won some concessions from the unions. There was some improvement on the war front. There was talk of government corporate welfare. Who really knows why, maybe the stock started to move too fast and short-sellers panicked and covered. Whatever the reason, the stock took off faster than a Boeing 777 with half the seats empty.

Before my eyes the stock was pushing $4 a share, from a buck fifty a few days before. I sold a little over half the position at $3.72 on April 2. The next day the stock kept moving up. I sold the rest at $4.56. When all was said and done the portfolio was up well over 130% since I became portfolio manager back in 2000. I beat 99% of mutual fund managers out there over the last three years and never had a down year.

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Knowing what created the performance, would you give me your retirement money to manage? Of course not, this was not investing, it was Las Vegas. I got lucky on a hunch, no smarter than some scruffy, chain-smoking old-timer at the OTB who has a feeling about a horse.

The Luck Factor

In many endeavors, talent is easily identifiable. People are most familiar with sports when it comes to identifying the best. Some athletes are blatantly better than others and you can easily predict they will do better in the future. Tiger Woods is more likely to win going forward than the average pro golfer. Jordan and Tyson, in their day, were unbeatable. Besides sports, raw talent is pretty obvious in singing and dancing, chess, computer programming, writing, art and a host of other professions.

Unlike basketball, boxing or golf, past performance of investors is not 99% skill. It's not 100% luck either, but luck is a force in investing. Fund mangers can, and do, get lucky, or can just be in the right place at the right time.

The luck factor is one of many reasons fund mangers with strong past track records do not continue to outperform with any degree of regularity. If past stars could continue to be above average, investing in funds would be a breeze: You'd just select whichever fund managers had done the best.

Of course, many investors do just this and wind up with average (or worse) performance. They don't believe, or more likely don't want to believe, that investing is not like sports. We don't want to think a manager might have gotten lucky because it's scary to think our retirement money may be managed not by a skilled and talented investment professional, but rather a gambler on a streak. We want to believe in talent. Talent is comforting. Luck is frightening.

There are thousands of managers running tens of thousands of portfolios. If you had 10,000 monkeys throwing darts at the stock pages and building diversified portfolios some would do extremely well, even for long periods of time. Mathematically it just happens. The fact that they can talk a good game after the fact doesn't mean luck played no role in the performance.

I've been reading analysts' and reporters' reviews of funds for a decade, and never once was the word luck used to even partially explain recent outsized past performance. If my account were a mutual fund and I told my story a little less honestly, someone would review it and say: "The manager deftly maintained a heavy cash and bond allocation during turbulent times for the market, never once succumbing to buy the dips as many have before. But don't accuse him of being a scaredy-cat, when opportunity strikes he will make big aggressive bets, as he did taking a bold contrarian position on AMR. It's paid off in spades, the fund has beaten every long stock fund out there. This fund is not for everybody, but those looking for an aggressive fund that stands apart from the crowd will find an interesting choice here."

After the tech wreck of 2000, some of the highflying funds continued to perform well. Fund analysts who previously chose other funds that collapsed in 2000 latched on to these managers, who must surely be more skilled than the others since their aggressive funds didn't fall. Funds like

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Red Oak Technology Select quickly became analyst and investor favorites.

It eventually tanked along with the others. The only reason some funds tanked later than the others was these funds were investing in areas like telecom, energy, health and biotech -- hot spots that crashed well after the initial technology sector wipeouts of 2000. Were these managers in these sectors in 2000 because they are smarter or did they just get lucky? You can never know for sure, but to not even consider the power of luck as a force is shortsighted.

Fortunately, mutual funds, unlike hedge funds, are not completely secretive about how performance was achieved. Diversification requirements limit blatant gambling-generated returns like I achieved. There are also ways to uncover streaks that may be luck-fueled and ones more skill-based. How diversified a fund was; how frequently trades were made; how much of the return was from good stock picking and how much was trading or sector bets that panned out; how consistently and lengthy were periods of good performance; how much risk was taken on compared to competitors; and how other portfolios run by the same person have done are all ways to shake out some luck from the system. But you'll never completely remove the dark force, just winnow it down and contain it.

Investors fall for luck-based returns in droves. The system makes it easy. Hedge funds trade in complete darkness, while mutual funds are more in the shadows -- visible but obscured. Every few months you'll read a headline in the paper about some hedge fund completely collapsing in value, sometimes in a matter of days. Often hundreds of millions were lost. How did they get hundreds of millions from investors to lose in the first place?

They didn't steal it, they raised it, showing a past track record to investors as scintillating as my own with AMR. Clearly some of these funds got lucky betting with a small portfolio, only to raise hundreds of millions with the fabulous track record. Investors got wiped out because they could not discern luck from skill.

The power of luck: Pretending it doesn't exist may be comforting, but it's not a good way to invest your money.