Philosophical Musings

April 27, 2007

The Problem with Munger’s Worldly Wisdom

Filed under: investing — Elad Kehat @ 7:43 am

I recently came across the transcript speech made by Charlie Munger, of Berkshire Hathaway fame, to the U of South California Business School in 1994. The speech, titled “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”, is both insightful and entertaining, which makes it a great read.
Nevertheless, I believe that there’s a big problem with the system that Munger recommends we use in managing our financial investments.
Essentially, what Munger suggests is that we limit ourselves to a very small number of investments (say 20 in a lifetime) and be very diligent about picking those few. Whenever we do find one that passes our extreme scrutiny, we should load on it, and stick with it for the long term.
Munger has a lot to show for his method – Berkshire Hathaway has been built on this system with a small number of exteremely successful investments that have multiplied tens of times in value over a few decades. These include Coca Cola, American Express, Walmart and The Washington Post, to name a few well known examples.
But is this system really a good choice for the average Joe? Say you’re like me, in your thirties, making a nice income in your day job, and trying to invest your savings well enough so that you can retire comfortably 30 or 40 years from now. What would be a wiser choice for you to follow, Munger’s system, or building a diversified portfolio from a bunch of market index ETFs that would guarantee you more or less average market performance?
Obviously, if you want above average returns, you can’t go with the market index funds option, and Munger offers good reasons why letting money managers play with your money isn’t very likely to give you that desired edge either (you’re more likely to get sub-par returns). However, let’s analyze the Munger system, and see whether you’re likely to be better off using it.
The Munger system – picking only a handful of stocks over your lifetime, sticking with them, and sticking for the long haul, requires you to be a very good stock picker. After all, if you only pick a handful, there’s not much room for error. It makes perfect sense – if you pick only winners, you’ll win big, but are you going to pick the winners?
That’s why Munger suggests that you pick just a few – you can’t know everything about everybody, so you better focus more narrowly. That assumption suffers on two fronts: (a) you don’t have the time, experience and access that Buffett and Munger have in order to focus as well as they do and (b) you’re simply not as good at recognizing the good from the bad as they are. There’s a reason that there’s only one Buffett. As Munger himself says, only one fifth can be at the top 20%, and this guy is at the top 0.00001%… To the genius it seems as if he’s just applying simple worldly wisdom, to the rest of us, he’s applying magic.
So what’s your outcome likely to be if you apply Munger’s system? Let’s use Munger’s worldly wisdom – the bell curve. The majority of stock pickers will make average picks, and overall get average returns, a minority will make above average return, and a small minority’s returns will be truly spectacular. The flip side is of course that there’s an equal minority who’ll make below average returns, and a small minority who’s returns will be just horrible.
Making just a few picks in your lifetime does not guarantee the quality of your picks. Moreover, the less attempts you make at stock picking, the more likely you are to be affected by chance than to let your skill shine through.
What it all comes down to is that on average, users of the Munger system will make average returns. The average in a bell curve (assuming that stock picking aptitude is distributed normally) also includes the majority, so that’s most likely where you’ll end up. No better than if you just invested in some index funds.
There’s still the minority that makes better returns, and there’s a fair chance that you’ll end up there. That’s great, but you have to remember that it’ll be your reward for taking a risk. The risk is that you have an equal chance to fall in the bottom of the bell curve, and then woe to you. For you have to keep in mind that it’s life savings that we’re gambling with here. If you have the bad luck of being one of the bad stock pickers who just thought he could strike it rich by taking additional risk, then say goodbye to your cozy retirement.
In short, while Munger is witty, insightful and funny, and while it’s terribly tempting to believe that you too can become a billionaire (or merely very well off) by following his simple strategy, you better be damned sure that you’re a way-above-average stock picker to follow that strategy in your spare time and expect to win.
As for me, I’m definitely not against risk taking – my friends think of some of my decisions as terribly risky, but I try to take risks only with the things I know, from experience and conviction, that I’m good at. My experience with stocks has taught me that stock picking isn’t one of those things, and so my savings are better off in an index fund making average returns.


1 Comment »

  1. […] market; good ideas hard to come by. One valid criticism of this sort of investment advice is that if you are an average individual investor rather than […]

    Pingback by Worldly Wisdom - Unintuitive Gains — December 25, 2011 @ 11:18 pm | Reply

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