Small mistakes can accumulate

By DAVID MOON, Moon Capital Management, LLC
December 16, 2012

While investors should always focus on the big, important things, there are plenty of small potential mistakes that can expensively accumulate over time.

While diversification is important, it is possible to enjoy too much of a good thing. It makes sense to buy 20 or 30 stocks rather than one. Or to buy a couple of mutual funds.

But if you own eight or ten mutual funds, you don’t have a portfolio, you have a collection. Your account is both everything and nothing at the same time. And you are likely paying hefty fees (or layers of them, if an advisor is involved) for the privilege of owning a homemade Wilshire 500 index fund.

Many investors are mis-fascinated with expenses. You should never pay more expenses than necessary. You should always receive value for any investment expense you incur.

Your investment goal, however, shouldn’t be to minimize fees. It should be to maximize return.

A study by Morningstar suggests that there is a negative correlation between mutual fund expenses and total return, but the study looked at all funds. The problem with this study is that it starts with the presupposition that no managers are more talented than any others.

A review of the long-term top performing active managers reveals that, with some exceptions, the best performing managers do tend to have higher-than-average expenses. But the reverse isn’t true; you cannot assume that a higher expense ratio will necessarily predict higher net returns.

The expense of an index fund is the only differentiating factor from other similar funds. But if you own actively managed funds, the extra expense of one manager may be more than justified by the return.

Anchoring is a common mistake, even among professional investors. It is a bias to rely too heavily, or almost exclusively, on your first piece of information when making subsequent decisions. For many investors this piece of information is their original cost. Once that anchor is set, all subsequent decisions are made from the standpoint of “what did I pay for it?”

Your cost is irrelevant to whether or not the price of a stock is likely to increase or decline from its current price. A stock doesn’t know what you paid for it. Nor does it know that some other investor paid more or less for his shares in the same company.

Even investors that try to focus on the important issues such as a company’s earnings can easily overlook details that conflict with the headline of a company’s earnings press release. For example, a November press release from Miller Energy Resources announced a new preferred stock dividend, implying a strengthening financial situation.

A review of the financial statements and related footnotes, however, reveal that most of the company’s cash is in a restricted account controlled by a lender. Miller borrowed $40 million in the first six month of this year. The company also reported an operating loss of $11 million, while recording almost $5 million of stock-based compensation.

The small things matter.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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