Friday, January 9, 2015

Charlie Munger on Focus Investing

Charlie Munger once said:

"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund."

It's simple.

There's plenty of low cost alternatives available.

Historically, index funds have performed better than the vast majority of active market participants over the longer haul.

So it at least seems a very reasonable prescription for many.

Well, what about those who think they aren't in the "know-nothing" category?

More from Munger:

"You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge."

Here's where his thinking gets more than just a bit less than conventional. He also happens to think, for those who are rightly confident and comfortable picking individual stocks, it makes little sense to diversify a whole lot.

"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way." - From Poor Charlie's Almanack

In a 1998 speech, Munger said he has "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."

So just how far from the "orthodox view" does he think it can make sense to go in some cases?*

"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."

That is, to say the least, far from conventional thinking, but the point is that diversification can be overrated.

Munger also once said:**

What's funny is that most big investment organizations don't think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach.

Now, the amount of portfolio concentration described above probably will likely be too extreme for most investors. It not only requires, after paying at least a fair price, having enough justified confidence in a very limited number of equities, it requires confidence that they will remain fine businesses long-term (and, as a result, will increase in per share value at a satisfactory rate).

So a concentrated portfolio becomes a recipe for real trouble for those who overestimate their own investing abilities. As always, it comes down to an awareness of limitations.

I think correctly judging which end of the spectrum -- with owning index funds being at one end, and owning a very limited number stocks at the other end -- is closer to the right approach for someone is easier said than done. At least it is based upon how poorly so many market participants have historically performed compared to the market overall.

At some level it comes down to knowing what you know and don't know.

Am I actually good at picking stocks?

Or am I getting into something I'm likely to not do very well?

It seems pretty clear that many don't quite get the answer to these kind of questions right. Too many think they're good at picking individual stocks and end up learning the hard way that they're just not; they attempt to outdo the market averages and, well, just don't in the long run. Lots of energy expended doing something that produces a result that's less than, all risks considered, what could have been accomplished simply buying a low-cost index fund (and learning to ignore the noise).

The reality seems to be that there are lots of active stock pickers --  some professional, some not -- who would be plainly better off NOT owning individual stocks. For these investors, index funds would not only improve long-term returns, they'd offer the bonus of additional free time to do something else more fruitful. I mean, the reality is that individual stocks often require a whole lot of work whether or not results turn out to be satisfactory.

Some might choose to think of an index fund as a way to simply match the "market average". Well, the word average is a distraction in this case. It turns out that, while it might called a "market average", it has hardly been an average result once frictional costs and mistakes are taken into account.
(i.e. If the vast majority of active participants are underperforming, then that by definition means simply matching the average is an outperformance. The word average in this context seems unfortunate.)

Now, it's worth pointing that index funds will only work if they're left alone over the long haul as the market (or individual stocks) goes through the inevitable -- occasionally rather wild -- fluctuations.

So fund investor behavior is a big factor and too often it is a negative one.

Unfortunately, it's the well-intentioned temptation to jump in and out of investments that too often contributes to bad outcomes. In other words, those fluctuations should either serve or be ignored. It's also worth pointing out that future expectations for long-term returns should probably be much reduced compared to the historic norms. Those who don't temper their long-term return expectations for the market as a whole going forward just might end up being rather disappointed.

As far as I'm concerned, though forecasters and fortune tellers will no doubt keep trying to prove otherwise, it's nearly impossible to know what's likely to happen in the future. The world for investors always has been, and always will be, an uncertain place. This reality need not adversely impact investment performance but too often that's exactly what happens. There's just no point in trying to foresee the mostly unforeseeable. Yet that doesn't stop smart people from wasting way too much energy trying to do just that. Instead of focusing on what's in their control (price paid, estimates of value, emotions, etc.) they focus on those things they mostly control or reliably predict.

I'll take someone any day who just says "I don't know" what an individual stock or the market as a whole is likely to do (near-term and even much longer) over those who are willing to make prognostications. Better to just expect difficult market conditions from time to time and realize that those difficulties may look nothing like those of the past; maintain reasonable but conservative expectations then end up pleasantly surprised if things go a bit better.

Also, having a flexible approach doesn't hurt.

Effectively picking individual stocks doesn't just come down to whether an individual possesses the necessary background technical abilities, it just as often comes down to psychological factors. For starters, it's not a bad idea to consider overconfidence the greatest enemy of all for investors. More generally, investing well means having a realistic sense of limits, abilities, and characteristics. Those that possess an ability to be sensible and long-term oriented when the markets become emotionally-charged from time to time (and they surely will!) have a big advantage.

So index funds, individual stocks, or some combination can be a logical approach depending on circumstances, skill set, and temperament (among other things). There is also, of course, a number of very capable active fund managers. It's one thing to identify who has done well in the past but it's much tougher to identify who will do well, over the long run, going forward.

In any case, no matter what the necessarily-unique-for-each-investor approach might be, lots of trading activity will likely do more damage (via additional mistakes and frictional costs) than good to long-term results. In other words, it's buying what makes sense consistently, trading minimally, then allowing those investments to compound over many years. The emphasis being on what's produced over time. Price and value should dictate investor action; market price action should not. Again, how prices fluctuate near-term or even longer should either serve the investor or be ignored.

Unfortunately, stocks are hardly cheap these days. So, for those with a long enough time horizon, a rising market is the last thing they should want right now. A rising market would make what is not particularly cheap even less so. More risk; less potential reward.

Whatever approach happens to make sense a very long time horizon is essential. Investment requires that the capital won't be needed anytime soon. Think decades not years.***

I'd add that who offer opinions on and attempt to understand hundreds of different stocks (and other investments) aren't acting in a way that's likely to produce great overall results. At least not for most of us mere mortals. Some skepticism seems in order for those who confidently offer a view on practically every investment alternative.

To me, the expert who frequently says "I don't know" when asked a question deserves credit instead of criticism. Though in itself insufficient, it's at least one indication that they're aware of their limitations.

Investment results are heavily influenced by the avoidance of big mistakes (i.e. permanent loss of capital that's substantial relative to the portfolio being managed). It's not that mistakes won't be made. In fact, they're unavoidable even for those who are very capable. The key is that they're kept small in relation to the overall portfolio. The possibility of a big gain should take a back seat the risk of permanent losses. Sticking with what you really know goes a long way towards this.

It's worth noting that Berkshire Hathaway's (BRKa) current size (and other factors) doesn't allow it concentrate the way it once did.

Still, if you look at the Berkshire equity porfolio, most of the dollars are invested in just five stocks.

It's also worth mentioning that, other than Berkshire's portfolio, the other (much, much, much smaller) portfolio that Charlie Munger apparently has some influence over these days is, I think it's fair to say, rather concentrated.

It's very much consistent with what Munger said above.

Adam

Long position in BRKb established quite a while back at much less than recent market prices. No intent to buy or sell near current prices.

Related posts:
The Seventh Best Idea
Index Fund Investing Revisited
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
Investor Overconfidence Revisited
Investor Overconfidence
Charlie Munger: Focus Investing and Fuzzy Concepts
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Munger also once said"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?"
** This Charlie Munger comment comes from notes taken by Whitney Tilson.
*** Returns measured over time frames like two to three years or less are essentially coin flips. I'd argue five years is the absolute minimum and more like ten to twenty years or longer should be the focus.
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