Charlie Munger: An Idiot Could Diversify A Portfolio!

Johnny HopkinsCharles Munger, Portfolio ManagementLeave a Comment

Here’s a great excerpt from Charlie Munger’s Daily Journal Meeting earlier this year in he discusses why portfolio diversification is completely unnecessary. He illustrates the point with a great real-life example saying:

The idea of diversification makes sense to a point if you don’t know what you’re doing and you want the standard result and not be embarrassed, why course you can widely diverse. Nobody’s entitled to a lot of money for recognizing that because it’s a truism it’s like knowing that two and two equals four. But the investment professionals think they’re helping you by arranging diversification. An idiot could diversify a portfolio! Or a computer for that matter. But the whole trick of the game is to have a few times when you know that something is better than average and to invest only where you have that extra knowledge. And then if you get just a few opportunities that’s enough. What the hell do you care if you own three securities and J.P. Morgan Chase owns a hundred? What’s wrong with owning a few securities?

Warren always says that if you lived in a growing town and you owned stock in three of the best enterprises in the town, isn’t that diversified enough? The answer is of course it is… if they’re all wonderful places. And that Fortune’s formula which got so famous which was a formula to tell people how much to bet on each transaction if you had an edge. And of course the bigger your edge, the more close the transaction was to a certain winner, the more you should bet… And of course there’s mathematics  behind it…

But of course it’s true. It’s perfectly possible to buy only one thing because the opportunity is so great and it’s such a cinch. There are only two or three. So the whole idea of diversification when you’re looking for excellence, is totally ridiculous. It doesn’t work. It gives you an impossible task. What fun  is it to do an impossible task over and over again? I find it agony. Who would want to do it? And I don’t see a way…

My father had a client, he was a lawyer in Omaha, he had a client whose husband had a little soap company. The guy died and my father sold the soap company. This woman was one of the richest people in town in the middle of the depression, and what she had was a little soap company and the biggest mansion in Omaha’s best neighborhood. When they sold the soap company she had a mansion in the best neighborhood and three hundred thousand dollars. But three hundred thousand dollars in nineteen thirty something was an incredible amount of money.

A little hamburger was a nickel a big hamburger was a dime, and the all you can eat cafe in Omaha would feed you all you needed to stay alive for two bits a day. I mean 300,000… Well she didn’t hire an investment counselor, she didn’t do anything, she’s a wonderful old woman. She just took that, she divided it into five chunks, and she bought five stocks. I remember three of them because I probated her estate. One of them was General Electric, one was Dow, one was Dupont, and I forget the other two. Then she never changed those stocks. She never paid any adviser. She never did anything, and she bought some municipal bonds, she never spent her income, and she bought some municipal bonds from time to time with the (inaudible). By the time she died in the 50’s she had a million and a half dollars. No cost. No expenses. I said, “How did you decide to do that?”

And “Well…” she said, “I thought electricity and chemistry were the coming things.” She just chucked it all in and sat on her ass. I always liked that little old woman. My kind of a girl. But it’s rare!

But if you stop to think about it, think of all the expense and palaver that she didn’t have to listen to and all the trouble she avoided, and zero costs. And of course what people don’t realize, because they’re so mathematically illiterate, is if you make 5 percent and pay 2 of it to your advisors, you’re not losing 40 percent of your future you’re losing 90 percent. Because over a long period of time that little difference causes a 90 percent disadvantage to you.

So it’s hugely important for somebody who’s a long term holder not to be paying a big annual toll out of the performance. And of course there are a few big time advisors now who are using indexation very heavily. And of course they’re prospering mightily. And of course every time they get somebody it’s just agony for the rest of the investment counseling business. This is a very serious problem.

And I think these people who were used to winning as old-time value investors who are now just quitting the profession. That’s a very understandable thing to do. I regarded it as more noble than staying in… you know… playing along with the denial. It’s an interesting problem.

You can see I’m not trying to make your morning.

[Laughter]

You can watch the entire meeting here:

(Source: YouTube)

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