Munger on the Dangers of Diversification

Charlie Munger’s speech Investment Practices of Leading Charitable Foundations, given at a meeting of the Foundation Financial Officers Group in Santa Monica, California, is often remembered for its criticism of excessive investment fees and unnecessary complexity. The speech also touches upon another widely-accepted investing practice he challenges: diversification.

The problem with diversification as dogma

Diversification is considered a cornerstone of prudent portfolio management, and for most investors, it serves an important purpose: don’t put all your eggs in one basket. And for decades, investors were taught that spreading money across as many businesses, sectors and geographies was the safest way to build long-term wealth. Munger felt differently.

• Diversification is not a diktat: Munger argued that diversification had become something of a dogma. Institutions were adding more investments not because each one improved the portfolio, but because conventional wisdom dictated that broader diversification was always better. In his view, this often led investors to dilute their best ideas in pursuit of “safety.”
• Concentration can be good: One of the most striking lines in Munger's speech is his assertion that a charitable institution/foundation/investor with almost all of its wealth invested in just three outstanding businesses could still become "securely rich" in the long run. Munger felt that if an investor truly understood a business, had confidence in it long-term, and invested at a sensible price, then concentrating capital in that one business could bring better results than scattered investments across a dozen different businesses.
• Discipline over diversification: Munger added that in some circumstances, a family or foundation could keep as much as 90% of its wealth invested in a single exceptional company. He gave the example of the Woodruff Foundations' long-standing concentration in Coca-Cola as an example of how conviction, combined with ownership of an extraordinary business, had rewarded investors. Concentrated portfolios require deep knowledge, emotional discipline and a willingness to weather periods of volatility and underperformance. If an investor lacks those qualities, or is unable to distinguish an exceptional business from an ordinary one, then broad diversification makes sense.

The enduring lesson…

Munger's views on diversification are often reduced to the headline that investors should own only a handful of stocks. That misses the deeper lesson. He wasn't advocating concentration for everyone. He was challenging investors to think more carefully about why they diversify in the first place. Yes, diversification can help reduce setbacks from being wrong. But it cannot pay for poor investment decisions, nor does it automatically improve returns. Beyond a certain point, adding more holdings may simply dilute the impact of your holdings. The enduring lesson is not that diversification is bad, it’s that every investment in a portfolio should have earned its place - simply owning more businesses does not make an investor safer or wealthier.