Portfolio manager Cale Smith’s riffs on investing, spoke funds, and Islamorada in the Florida Keys.

Must-read article in yesterday’s WSJ:

The Hidden Costs of Mutual Funds

Portfolio managers can rack up steep expenses buying and selling securities, but that burden isn’t reflected in a fund’s standard expense ratio.

How much does it cost you to own a mutual fund? Probably a lot more than you think.

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how costly a fund is to own. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.

But that’s not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

“These trading and transaction costs are very real,” says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. “While it’s very important to look at that expense ratio, it’s just not going to capture” all of the costs, Mr. Horan says.

Read the entire article here. Morningstar’s estimates of the average fund expense ratio in the above is lower than the industry’s own estimates. I compare mutual fund costs to spoke fund costs here. And sign up here to receive my article “Ten Things You Must Know Before Investing in Mutual Funds.”

This is one of my favorite Saturday mornings of the year. Not just because there’s a full moon party at Morada Bay tonight. Warren Buffett’s latest letter to shareholders was released today. It’s a great intro to the business of Berkshire Hathaway, and I’d encourage Tarpon Folio investors to read it. After all, it’s your business, too. I highlighted some of the best quotes below.

On successful investing:

We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.

On the bailouts of last year:

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.

And, in case you’re wondering – yes, although it looks a bit odd, apparently it is acceptable to spell “benefitted” in the above with two t’s. But I had to Google that to be sure.

Uh, did I mention I get a bit obsessed with these letters?

Anyway, the best quote attributed to Charlie Munger:

Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?

And the closing thought:

At 86 and 79, Charlie and I remain lucky beyond our dreams. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to that experienced by many people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped in countless ways by talented and cheerful associates. Indeed, over the years, our work has become ever more fascinating; no wonder we tap-dance to work. If pushed, we would gladly pay substantial sums to have our jobs (but don’t tell the Comp Committee).

Here’s the letter in its entirety.

And if you’re thinking about going to Omaha for the annual meeting on May 1st, please let me know!

Q. How many stocks should I own?

A. I’d like to clarify two points for new readers. The first is that I believe that the majority of long-term investors are best served by investing in an index fund – a widely diversified, passively managed fund built just to match the performance of the whole stock market.

The second point is that if you’re going to build a focused portfolio containing a limited number of stocks, you either have to really know what you’re doing or find someone that does. One of my favorite quotes sums this up well: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

My own beliefs about diversification are the opposite of conventional Wall Street wisdom. In short, while diversification can play an important role in protecting overall wealth, I believe it is of limited use when you are trying to really grow a specific portion of your assets. It is simply a mathematical fact that the more stocks you own in your portfolio, the lower the odds are that you’ll be able to outperform an index fund.

In addition, putting your money to work in your best ideas also just makes more intuitive sense to me. If you own four stocks and one increases by 50% while the rest stay flat, your total portfolio will gain 12.5%. If you own 100 stocks and one increases by 100%, your portfolio is only up 1%. Why put money in your 76th best idea?

I believe you can reduce risk by deeply understanding the companies you invest in, as well as knowing their real value, not by spreading the risk across more companies. I see danger in owning too many investments because it becomes too hard to closely follow the progress of too many businesses.

So you probably don’t need to know more than a dozen companies really well over the course of your life to become wealthy. But you do have to know them very well.