Editor’s note: This article was first published in August 2013 in the present tense about Charlie Munger, who died in November 2023.
In the first part, Charlie Munger gave us his views on active and passive investing. This time he shares his view (and the one Berkshire Hathaway has applied) on diversification when investing, or what Munger calls concentrating capital in stocks.
Those who have already read Warren Buffett’s investment advice can probably guess that Munger also sees excessive diversification as a way of protecting yourself against ignorance, but Munger explains it in a way we can understand perfectly.
We take it for granted that when we invest we must study a company thoroughly, understand its business model, appreciate its value as a company and recognise its future prospects. Since the more we know about the company we are going to invest in, the better our chances of getting the investment right, it is better to know a lot about a few companies than a little about many.
Munger tells us that one of the most remarkable things about successful investors is that they “bet” very rarely. It is very simple. Practically nobody has the talent to know everything about everything all the time, but through hard work and dedication to analysing a company, we can sometimes find a clear opportunity (a company with potential at a low price). Wise, intelligent investors bet very heavily when they come across that opportunity, and the rest of the time they simply aren’t betting (investing). It is that simple.
Practically nobody in investment management operates this way, yet the truth is that concentrating capital in a few stocks is the key to achieving excellent returns.
Excessive diversification is madness
According to Munger, excessive diversification as a rule includes investing in mediocre companies, so it only guarantees mediocre results.
Munger and Buffett say that the number of stocks you should own to reduce portfolio risk within a sensible diversification would be 10, or 15 at most. Benjamin Graham himself said you should hold between 10 and 30 stocks, although, according to Graham’s history, the year he diversified most was the year he made a loss: many of the mediocre stocks he had included out of the need to diversify in the face of a crisis wiped out practically all the gains from the great companies Graham held in his portfolio.
Munger says that investors who follow Berkshire’s style of investing tend to diversify less than other investors, and states that today’s academics have done investors a disservice by glorifying the idea of diversification. He repeats that, rather than spreading your money across a large number of stocks, it would be much more profitable to invest in an index fund, where even the costs and fees would be lower.
Munger says he has even known venture capital investors who also start from the idea of diversification and have put small amounts of money into 200 entrepreneurs’ projects, giving each of those 200 companies just enough instead of generously backing the projects with the best chances. If it is done as charity, the idea sounds good and the entrepreneurs should be grateful, but if you are investing to make money it is a serious mistake: statistics say that more than half of those projects will not survive, so part of the money you have thrown at a large share of projects could have secured the success of others whose path looked much clearer.
In short
Today’s economists talk about market efficiency, and the truth is that markets can be very efficient. Sometimes the market is right about a stock’s price, but it is not always right.
It is possible to find a period or a situation in which we come across an investment for much less than it is worth. How much is “much less than it is worth”, you may ask? The price has to be so good that you are eager to buy.
How often do these situations arise?
A good investment opportunity may come along once or twice a year, although we may also find one three times in a month, or only once in three years. There have been renowned investors who did not make a single investment in the market between 2007 and 2009.
To identify these opportunities to invest in undervalued stocks, it is important to specialise in an area where you are highly competent. If you try to be competent in every area and field, you will never be smart enough to find those investment opportunities.
Munger concludes that they don’t believe markets are completely efficient, nor that widespread diversification gives good results. They believe almost all good investments will involve low diversification. Probably only 2% of investors use this method, while the remaining 98% simply believe what they have been taught.
Further reading
- What I learned about stock market investing at the gym
- The 7 immutable principles of investing
- 3 investment ideas that can get you into trouble
Featured image: Cumberland Telephone & Telegraph Company, Public domain, via Wikimedia Commons.
