Munger on the Dangers of Complexity in Investing

In 1998, Charlie Munger, the legendary investor and Vice Chairman of Berkshire Hathaway, gave a speech called Investment Practices of Leading Charitable Foundations at a meeting of the Foundation Financial Officers Group in Santa Monica, California.

The speech is a critique of how large charitable foundations and university endowments managed their money. But beneath the discussion on institutional investing lay several lessons that apply to individual investors as well: how complexity and taxation can eat into returns, why diversification may dilute returns, and how overconfidence is more dangerous than fear.

Here, we look at Munger’s argument that complexity can actually be detrimental to earning long-term returns.

Complexity comes at a cost

One of the key themes in the speech is how the growing layers of people involved in decision-making for trusts hampers growth.

Too many cooks: A charitable foundation often hires consultants. Those consultants rope in fund managers, who, in turn, rely on research from Wall Street analysts and researchers to help them get the job done. In this setup, every layer needs to make money — which translates into advisory fees, management fees, brokerage commissions, trading costs and multiple other expenses.

The hidden cost is 3%: Munger estimated that these combined costs could easily eat up around 3% of a foundation's assets every year. It may sound like a small number, but we need to remember that investing is a game of compounding. Every percentage point paid in fees is a percentage point that no longer compounds for decades. He illustrated this with a simple example. Imagine a portfolio earning a 5% return over the long run. If investment costs consume 3% annually, only 2% remains before any spending. So foundations may be left with a shrinking pool of capital (especially if they distribute some of their assets every year) in spite of reasonable market returns.

How it translates to individual investors: Individual investors may not engage multiple consultants, but they may unconsciously recreate that complexity, by investing in overlapping mutual funds, switching between fund managers, chasing new sectors every year, etc. The portfolio becomes so complicated, they lose sight of what they actually hold. Every additional layer or fund introduces costs both visible and hidden costs.

The enduring lesson…

What Munger is trying to say is that good investing is not about creating a portfolio that appears sophisticated, but about effectively compounding wealth over a long period. Complex portfolios, multiple advisors and constant activity can create the impression of diligence and good returns. But every additional layer adds friction and costs in the form of fees, taxes, etc. Munger believed that investors who focused on keeping costs low, avoided unnecessary activity, and allowed  compounding to do its work could outperform elaborate strategies.