I am skeptical of the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment.
In recent years there has been a drift toward more complexity. Now huge diversification consists of hiring many investment counselors, chosen by an additional layer of consultants. These consultants, in turn, also help in allocating assets, in making sure foreign securities are not neglected in favor of domestic securities, in ensuring that investment styles are scrupulously followed and in conforming to the latest notions of corporate finance professors about volatility and beta.
I think the orthodox view is grossly mistaken.
But, you may think, my institution, at least, will be above average. It hires the best and considers all investment issues at length and with objective professionalism.
To this I respond that an excess of what seems like professionalism will often hurt you horribly -- precisely because the careful procedures themselves often lead to an overconfidence in their outcome. Smart, hard-working people aren't exempted from professional disasters caused by overconfidence. But suppose an abnormally realistic institution fears a poor future investment outcome. What are its options in seeking improved prospects? There are three choices:
1. It can both dispense with its consultants and reduce its investment turnover by moving to indexed equities.
2. It can follow the example of Berkshire Hathaway and get total annual croupier costs below 1/10 of 1% of principal per annum by investing with virtually total passivity in a very few, much-admired domestic corporations. Outside advice can be used in this process -- all the fee payer has to do is suitably control the talent in investment counseling organizations so that the servant becomes the useful tool of its master, instead of serving itself under the perverse incentives of a sort of Mad Hatter's tea party.
3. It can supplement unleveraged investment in marketable equities with investment in limited partnerships.
For the obvious reasons, I think the first choice -- indexing -- is wiser for the average institution than what it is doing now in unleveraged equity investment. Indexing can't work well forever if almost everybody turns to it. But it will work all right for a long time.
As for the third choice, there are two things to keep in mind regarding leveraged buyout funds.
The first is that buying 100% of corporations with much financial leverage and two layers of promotional carry (one for the management and one for the general partners of the LBO fund) is not guaranteed to outperform equity indexes in the future if equity indexes should perform poorly. The debt could prove disastrous if future marketable equity performance is bad.
The second consideration is increasing competition. General Electric Co. now can buy more than $10 billion worth in the LBO market per year with its credit corporation, with 100% debt financing at an interest rate only slightly higher than the U.S. government is paying. This sort of thing isn't ordinary competition but supercompetition.
And there are now many LBO funds, both large and small, mostly awash in money and with strong incentives for general partners to buy something.
In short, in the LBO field, there is a buried covariance with marketable equities -- toward disaster in generally bad business conditions -- and competition is now extreme.
This brings us to the question of how much investment diversification is desirable.
Concentration of investments can be a rational choice. The Woodruff Foundation has, so far, proven extremely wise in retaining an approximately 90% concentration in the founder's Coca-Cola Co. stock. It would be interesting to calculate just how all American foundations would have fared if they had never sold a share of their founder's stock. Very many, I think, would be much better off.
Another aspect of Berkshire's equity investment practice deserves comparative mention. So far, there has been almost no direct foreign investment at Berkshire, and much by other institutions. Regarding this divergent history, I wish to say that I agree with Peter Drucker that the culture and legal systems of the United States are especially favorable to shareholder interests, compared with other interests and compared with most other countries. This factor is underweighted at many investment institutions, probably because it does not easily lead to quantitative thinking using modern financial technique. But an important principle doesn't lose its validity as a force because some "expert" can better measure other types of force. Generally, I tend to prefer Berkshire's practice of participating in foreign economies through the likes of Coca-Cola and Gillette over direct foreign investment.
To conclude, I will make one controversial prediction and one controversial argument.
The prediction is that, if some of you make your investment style more like Berkshire Hathaway's, in the long term you will be unlikely to have cause for regret, even if you can't get Warren Buffett to work for nothing. Instead, Berkshire will have cause for regret as it faces more intelligent investment competition. But Berkshire won't actually regret any disadvantage for your enlightenment. We only want what success we can get despite encouraging others to share our general view about reality.
My controversial argument is an additional consideration weighing against the complex, high-cost investment modalities becoming ever more popular. Even if, contrary to my suspicions, such modalities should turn out to work pretty well, most of the money-making activity would exacerbate the current, harmful trend in which ever more of the nation's ethical brain power is attracted into lucrative money management and its attendant modern frictions, as distinguished from work providing much more value to others. Money management does not create the right examples of work. Early Charlie Munger is a horrible career model for the young, because not enough was delivered to civilization in return for what was wrested from capitalism.
Charles T. Munger is vice chairman of Berkshire Hathaway Inc. His commentary is adapted from a speech he delivered in October 1998.