Thursday, September 3, 2009

Munger & Buffett on Diversification - Part II

From a speech given back in 1998 by Charlie Munger:

"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. It would be interesting to calculate just how all American foundations would have fared if they had never sold a share of founder's stock. Very many, I think, would now be much better off." - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group
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The Warren Buffett/Charlie Munger approach rejects the idea that vast diversification is always needed. Risk can be reduced, in their view of the world, by concentration on a few holdings.

"Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts." - Warren Buffett in the 1978 Berkshire Hathaway Shareholder Letter

"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter


Over the years, much of the time, 70% or so of Buffett's equity portfolio was concentrated in, give or take, something like five holdings.
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Having said that, those with less investing skill and experience clearly require more diversification.

For some investors, index funds may make more sense than buying individual stocks. It's important to know which is your comfort zone before investing a penny.

Either way, whether investing in stocks or funds, it's always key to keep the trading and other forms of frictional cost to a minimum.

As always, know your limits and stay well within them.

Adam

Related post: 
Munger & Buffett on Diversification

Charlie Munger in Philanthropy magazine

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