Wednesday, June 3, 2009

Munger & Buffett on Diversification

"Some foundations, following the lead of institutions like Yale, have tried to become much better versions of Bernie Cornfeld's 'fund of funds.' This is an amazing development. Few would have predicted that, long after Cornfeld's fall into disgrace, leading universities would be leading foundations into Cornfeld's system." - Charlie Munger in a 1998 speech to the Foundation Financial Officers Group

The above speech covers, among other things, why Munger believes the accepted thinking on diversification is incorrect. More excerpts from the speech:

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken. 

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. I go even further. I think it can be a rational choice, in some situations, for a family or a foundation to remain 90% concentrated in one equity. Indeed, I hope the Mungers follow roughly this course. And I note that the Woodruff foundations have, so far, proven extremely wise to retain an approximately 90% concentration in the founder's Coca-Cola stock." - Charlie Munger

Munger then added Ben Franklin required this kind of concentration as an investment practice for his own charitable endowment. He continues:

"To conclude, I will make one controversial prediction and one controversial argument.

The controversial prediction is that, if some of you make your investment style more like Berkshire Hathaway's, in a long-term retrospect you will be unlikely to have cause for regret, even if you can't get Warren Buffett to work for nothing. Instead, Berkshire will have cause for regret as it faces more intelligent investment competition. But Berkshire won't actually regret any disadvantage from your enlightenment. We only want what success we can get despite encouraging others to share our general views about reality.

My controversial argument is an additional consideration weighing against the complex, high-cost investment modalities becoming ever more popular at foundations. Even if, contrary to my suspicions, such modalities should turn out to work pretty well, most of the money-making activity would contain profoundly antisocial effects. This would be so because the activity would exacerbate the current, harmful trend in which ever more of the nation's ethical young brainpower is attracted into lucrative money-management and its attendant modern frictions, as distinguished from work providing much more value to others. Money management does not create the right examples. Early Charlie Munger is a horrible career model for the young, because not enough was delivered to civilization in return for what was wrested from capitalism. And other similar career models are even worse.

Rather than encourage such models, a more constructive choice at foundations is long-term investment concentration in a few domestic corporations that are wisely admired.

Why not thus imitate Ben Franklin? After all, old Ben was very effective in doing public good. And he was a pretty good investor, too. Better his model, I think, than Bernie Cornfeld's. The choice is plainly yours to make." - Charlie Munger

As usual, these ideas are at odds with: 1) what is practiced by many professional money managers and, 2) what continues to be taught at most business schools.

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea." - Warren Buffett speaking at the University of Florida in 1998

Having said that, clearly a number of investors require more diversification. A concentrated portfolio of individual stocks requires a high level of warranted confidence in one's own ability to evaluate individual stocks.

Overconfidence in (or overestimating) abilities usually leads to terrible outcomes.

The fact is that, for many investors, index funds will make a whole lot more sense.

"Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals." - From the 1996 Berkshire Hathaway Shareholder Letter

Where this all tends to go wrong is that too many participants end up trying to trade in and out of what they own (whether it happens to be individual stocks or mutual funds).

The result? Lots of unnecessary mistakes and added frictional costs along the way.

They behave this way, of course, thinking that it will enhance returns but end up with just the opposite outcome.

In any case, it's important to make a realistic individual assessment. There's just no way around the reality that an appropriate comfort zone is necessarily unique to each investor.

Know limitations and stay well within them.

Adam

Related post:
Munger & Buffett on Diversification - Part II (follow-up)

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