Charlie Munger Isn't Big on Diversification

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- By Stepan Lavrouk

Charlie Munger (Trades, Portfolio) likes to say that he doesn't own many stocks. He owns shares of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), the Daily Journal (NASDAQ:DJCO), Costco (NASDAQ:COST) and has some of his money managed by Li Lu, who runs Himalaya Capital, a value investing-oriented fund with a focus on Chinese equities.

Munger does not believe that investors should pursue diversification as a primary strategy. At the Daily Journal annual shareholder meeting back in 2019, Munger used a historical anecdote to explain why he believes diversification is overrated.

You can't be widely diversified and outperform the market

Munger began by saying that diversification can make sense for individuals who are just trying to hit the market average. This is the basic idea behind owning an index fund - perfect diversification across a basket of stocks that will give you average returns every year. If the market is up 10% in a year, you are up 10%, and vice versa if it goes down 10%.

Munger's grip is with people - especially money managers - who think that they should be entitled to higher than average returns just because they have widely diversified portfolios. At the meeting, he said with his customary bluntness that "an idiot could diversify a portfolio."

The trick to success is to find the rare opportunities when the stocks that you own are better than the average. These opportunities will necessarily be few and far between, because public markets are (usually) pretty efficient, and there are probably only a few such companies that lie within your personal domain of expertise.

Next, Munger recounted a story from his youth about a wealthy widow who lived in Omaha in the 1930s:

"This woman was one of the richest people in town in the middle of the Depression. She had $300,000, which in 1930-something was an incredible amount of money... She didn't hire an investment counsellor, she didn't do anything like that - she just divided it into five chunks and she bought five stocks - I remember three of them: General Electric, Dow, DuPont - I forget the other two. And she never changed those stocks - she never paid any advisors, and only bought some municipal bonds with her unspent income. By the time she died in the 50s, she had $1,500,000! No costs, no expenses."

He went on to point out that, because of compounding, paying investment advisors ends up costing more than most people think. If you make 5% a year and your money manager takes 2% off of that, the net reduction in your savings down the road is not 40%, it's closer to 90% because of all the lost compounding. In Munger's mind, too many professional money managers just track indices and offer average results while promoting excessive diversification.

Of course, not everything is so simple - in reality, Berkshire and Himalaya Capital both own a variety of different businesses, sometimes as part of their stock portfolios, and sometimes (in Berkshire's case) as wholly-owned subsidiaries. So Munger is indirectly diversified in this way.

With that being said, he clearly has an in-depth understanding of his holdings, and this is the main point of his remarks - you need to be an expert in the things that you invest in, and the more stocks you own, the less likely it is that you will be an expert on all of them.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.

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