“Diversification is for the know-nothing investor.” — Charlie Munger
Mistake One: Diversifying too much
It was May 3rd, 2008. The two leaders, Warren Buffett and Charlie Munger–aged 77 and 84, respectively–of the Berkshire Hathaway corporation, sat on stage to take questions from an audience of 30,000 shareholders. At one point, a shareholder asked about how elite business schools teach investing.
Munger: “They say, the whole secret of investment is diversification. They’ve got it exactly back-assward. The whole secret of investment is to find places where it’s safe and wise to non-diversify.”
Buffett: “You will find opportunities that if you put 20% of your net worth in it you will have wasted the opportunity of a lifetime in terms of not really loading up.” (Previous to this statement, Buffett said that, working with small sums of money, there will be investments in which, “It would be a mistake to not have half your net worth in.”)
Munger: “Diversification is for the know-nothing investor.”
On Forbes’ list of the 400 richest Americans, three of the top fifteen are from one family: the Waltons. Their father, Sam Walton, founded Walmart in 1962. Jeff Bezos, Warren Buffett, Mark Zuckerberg, and Elon Musk all derive the majority of their wealth from single companies. Most investors–including professionals–own 20, 30, or hundreds of stocks. An investor’s 30th stock pick is unlikely to be as good as the top five. Diversifying too much can increase risk.
However, if you’re a novice investor uninterested in researching and valuing companies, it’s a mistake to put all your money into a few investments. Buy an index fund. Yet, you can overdiversify in index funds too. Many–most–wealth managers make money investing in too many index funds to justify their cost to clients. In the 2013 letter to shareholders, Buffett advised, “Put 10% of the cash in short-term government bonds and 90% in a very low-cost index fund. (I suggest Vanguard’s.)” Spread out your index fund investments over multiple years to avoid the risk of investing all in an overvalued market.
Mistake Two: Waiting to invest
Compound interest examples–invest $1,000 a month for the next 30 years and you’ll be a millionaire–don’t motivate. Multiple decades is a long time to wait to get rich.
There is a faster path.
To start, spend less than you make. Avoid high interest debt–it is easy to remain poor if you pay 24% to a credit card company.
Invest your savings. You won’t get rich anytime soon buying a few hundred dollars per month of an index fund; if you invest $200 per month at 8%, it takes you 46 years to accumulate $1 million. You won’t get skinny skipping a morning donut, yet you must. Small changes beget transformations. To gain freedom, create an investment account, contribute a portion of each paycheck, forgo purchases, increase your income, and see your investments grow.
On an episode of Dave Ramsey’s podcast, a couple employed with the National Guard described how they paid off an $800,000 house and saved an additional $300,000. They delivered packages for Amazon starting at 3:30 in the morning, worked at their normal jobs starting at 9:00, then delivered more packages for Amazon in the evening. They’re now millionaires–no longer delivering packages–with zero debt. The fast path to wealth and freedom is available to you; you supply the grit.
Mistake Three: Gambling
To buy a stock is to buy ownership in a business; it is not to pull a slot machine handle. Business performance determines stock prices, eventually. To buy stocks for reasons other than business merit is gambling.
In roulette, a dealer spins a ball around a wheel with 38 numbers. A board above the wheel displays recent winning numbers. A gambler sees a streak–five red numbers–and thinks, “Red must be lucky,” and wagers more. Financial pundits learned from casinos. They share stock charts with arrows and flashing numbers, alerts, and streaks.
When buying a home, we inspect similar houses, the neighborhood, local schools, quality of construction, reputation of the builder. Before buying a stock, inspect the competitors, industry, vendors, quality of products, skill of management. To assess a stock’s investment prospects, study its business quality, not its price chart.
Mistake Four: Buying at any price
Tesla produced $97 billion in sales and $12.7 billion in earnings in the last 12 months. Its market value is $1.5 trillion–15 times sales and 118 times profit. Should earnings remain at their current level, to make money buying its stock will take 118 years. A great business can be a bad investment.
Microsoft produces $254 billion in sales and $91 billion in earnings. Its market value is $3.4 trillion. Had you bought its stock at the peak of the dot com bubble in 2000, however, you’d have lost money for 15 years.
Before buying a stock, calculate its value. Estimate how much cash the business will produce for 10 to 20 years and the value of the business at the end of that period. Reduce those future cash amounts by 5-6% per year. The discounted total is the maximum the business is worth today. Divide that amount by its number of shares outstanding. Only buy if its stock price is half, or less, its value. As Joel Greenblatt, former hedge fund manager, said in The Little Book that Beats the Market, “The secret to investing is relatively simple: Figure out the value of something and then pay a lot less.”
Mistake Five: Selling too soon
If we buy the right company, the time to sell is never. Great businesses are rare. Such businesses have leading products, strong positions in growing markets, exceptional managers, protection against competition. Great businesses often surprise positively; poor businesses often surprise negatively.
When do we sell stock of business that’s not great? Value investor Mohnish Pabrai advises, “Any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.” Don’t sell a stock because its price declined, unless you’re confident its value declined as well. Otherwise, wait two to three years for its price to approach its value.