How to Profit From This Incredible Fiasco

Merrill Lynch managed to incinerate a good portion of its stock price and dominate headlines briefly last fall through a combination of corporate scandal, outrageously poor asset allocation, and insane managerial compensation.

Let's see what we can learn from Merrill's story -- the mistakes that cost its shareholders about $50 billion in market valuation over seven months reveal a large chunk of what you need to know to succeed in mutual fund investing.

1. Don't overcommit to the hot sector.
On Nov. 4, The New York Times listed Merrill's write-down of $8 billion on its subprime derivatives portfolio as the biggest in Wall Street history. That record lasted until Nov. 5.

Citigroup's revelation of $8 billion and $11 billion write-downs on that day has subsequently been eclipsed by the news out of Bear Stearns, UBS, and others.

Apparently, after seeing others make big money off the subprime mortgage market, top management at Merrill (and many others including Deutsche Bank (NYSE: DB  ) , Barclays PLC (NYSE: BCS  ) and HSBC Holding (NYSE: HBC  ) ) went into it in a very big way. However, Merrill was getting in right at the end of the money train.

Jumping into what has already performed well -- with hopes that the immediate future will mimic the immediate past -- is a very common investing mistake. It's what had mutual fund investors flocking into tech funds loaded with pricey shares of Akamai Technologies (Nasdaq: AKAM  ) , and Dell (Nasdaq: DELL  ) at the peak of the Nasdaq bubble of 2000, and it's what has people piling into China funds today.

Some developing-market funds containing names such as (Nasdaq: CTRP  ) and Wimm-Bill-Dann (NYSE: WBD  ) may once again be defensible long-term investments. But they won't be for a huge percentage of your capital -- unless you can ride out a continuing, potentially significant correction. Learn from Merrill's mistakes so that you won't be staring down a sizeable loss of capital as well.

2. Don't pay management too much.
Merrill rewarded Stanley O'Neal, its CEO until late October, with an exit package worth about $160 million. This appears to be compensation O'Neal was owed contractually, no matter how poorly he performed.

Outrageous compensation packages are par for the course on Wall Street, and they point to other common outrages -- namely, the salaries mutual fund managers are paid. Management fees come directly out of shareholders' potential profits and average more than 1.5% per year.

High annual fund expenses bear an extremely high correlation with fund underperformance. When investing in funds, don't be like Merrill; find managers that take a reasonable cut for reasonable pay -- less than 1.0% annually. 

3. Be very careful when you buy advice.
Somewhat lost in the headlines is that Merrill has just advised 100 of its pension fund clients that the SEC is investigating its pension reference business.

To make a long story short, Merrill consultants are being investigated for steering clients toward pensions without properly advising those clients about potential conflicts of interest -- like say, taking a big cut from the pensions for the "services." Surprise! That's the exact practice that has led to broker-sold mutual funds drastically underperforming funds chosen by individuals without the "help" of brokers.

When you're choosing mutual funds, always make it a practice to choose your own. The difference in results over time is staggering.

If you don't know how to choose your own funds, how to find promising areas that are not necessarily "hot," how to keep management costs low, and a few other crucial elements, Motley Fool Champion Funds is here to help. Take a 30-day no-risk, free trial today to find out more.

This article was first published Nov. 12, 2007. It has been updated.

Bill Barker does not own shares of any company mentioned. Akamai is a Motley Fool Rule Breakers recommendation. Dell is a Stock Advisor and Inside Value pick. is a Hidden Gems selection. The Motley Fool has a disclosure policy.

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