Renowned investor and Berkshire Hathaway Inc. Vice Chairman Charlie Munger is no stranger to controversial statements when it comes to investment philosophy.
One of his most contentious views is on diversification, which he famously refers to as "deworsification." According to Munger, the traditional approach to diversifying investments may not be the wisest strategy.
During the 2019 Daily Journal Annual Meeting, Munger responded to a question about diversification with a memorable analogy.
"Diversification gives you an impossible task. I find it agony," he said.
Munger went on to share a story from the 1930s about a wealthy widow who invested $300,000 in just five stocks, including General Electric Co., Dow Inc. and DuPont. By the time she died in the 1950s, her wealth had grown to $1.5 million without incurring costs or expenses.
Munger emphasizes the impact of compounding and warns against paying investment advisers. High fees can significantly erode savings over time, making it essential to be cautious of excessive diversification and average results.
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Munger's core argument against diversification lies in the potential trade-off between safety and returns. While diversifying across multiple assets may help mitigate risk and protect against significant losses, it may also limit the upside potential for high returns. Munger believes that investors who spread their capital thinly across numerous stocks may not fully capitalize on the exceptional growth of a select few.
This is more true than ever, with retail investors having broad access to various markets and a constantly shifting investing landscape. Robinhood Markets Inc. has democratized access to investing in the stock market. And companies like StartEngine allow anyone to invest in startups and high-growth private businesses, including the company itself.
Instead of favoring diversification, Munger advocates for a concentrated approach, where investors focus on a handful of outstanding businesses they thoroughly understand. He believes that by closely examining and comprehending these businesses, investors can make more informed decisions, resulting in a higher likelihood of achieving exceptional returns.
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Another critical aspect of Munger's criticism of diversification is the "dilution of knowledge" that can occur when investors hold a vast array of stocks. When an investor owns numerous positions, it becomes challenging to keep up with each company's developments, industry trends and competitive landscapes. This lack of in-depth knowledge can lead to subpar decision-making and potential missed opportunities.
Munger's strategy is well-reflected in Berkshire Hathaway's investment portfolio. Rather than spreading its capital across hundreds of stocks, Berkshire Hathaway's holdings are concentrated in a select few companies. As of 2023, the top 10 holdings accounted for over 90% of the entire portfolio's value.
It's essential to recognize that Munger and partner Warren Buffett are not infallible. Berkshire Hathaway's portfolio has had its fair share of misses, and a prime example is its long-standing investment in Wells Fargo & Co. In recent years, the stock underperformed the market because of several scandals that plagued the bank.
Despite the apparent success of Munger's deworsification strategy, it's crucial to acknowledge that no investment approach is foolproof. Investors must remember that concentrated portfolios also carry inherent risks. The fortunes of a concentrated portfolio are highly dependent on the performance of the chosen few companies, leaving less room for error.
Whether an investor follows Munger's approach or opts for diversification, the decision must be made based on individual circumstances, risk tolerance and investment goals. While Munger's philosophy may have worked well for Berkshire Hathaway, it may not be suitable for everyone.
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