Merrill Lynch managed to incinerate a good portion of its stock price and dominate headlines in recent months 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 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 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 (and numerous others, including Credit Suisse
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 Microsoft
Some developing-market funds containing names such as Golden Telecom
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 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 approximately 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 who are taking a reasonable cut for reasonable pay -- less than 1% 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 (for instance, 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.
This article was first published Nov. 12, 2007. It has been updated.