How to Profit From This Incredible Fiasco

Merrill Lynch (NYSE:MER) has managed to incinerate a good portion of its stock price and dominate headlines in the last couple of weeks through a combination of corporate scandal, outrageously poor asset allocation, and insane managerial compensation. Let's try to learn from its story -- the mistakes that have cost Merrill Lynch shareholders about $40 billion in market valuation over the past five 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 only lasted until Nov. 5, with Citigroup's (NYSE:C) revelation of $8 billion and $11 billion write-downs, but it's still impressive. Apparently, after seeing others make big money off the subprime mortgage market, top management at Merrill 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 the hopes that the immediate future is going to 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 Amazon.com (NASDAQ:AMZN) and Cisco Systems (NASDAQ:CSCO) 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 PetroChina (NYSE:PTR), Companhia Vale do Rio Doce (NYSE:RIO), and Baidu.com (NASDAQ:BIDU) may still be defensible long-term investments, but not for a huge percentage of your capital if you can't ride out a potentially significant short-term correction. Learn from Merrill's mistakes so that you won't be staring down a potentially significant loss of capital as well.

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

Outrageous compensation packages are par for the course on Wall Street, and they point to other commonplace outrages -- namely, the amounts that mutual fund managers get 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 are taking 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 them about potential conflicts of interest from 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.

The Foolish bottom line
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, including 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.

Bill Barker does not own shares of any company mentioned. Amazon.com is a Motley Fool Stock Advisor recommendation. Baidu is a Rule Breakers pick. The Motley Fool has a disclosure policy.