Charlie Munger on “Loading Up,” Tracking Error, and Value Investing
Back in 1994, Charlie Munger gave a talk to students at the USC Business School (a copy is here), covering topics ranging from mathematics and behavioral psychology, to pari-mutuel systems and investment management. As usual, it was a wide-ranging and fascinating speech.
One thing that’s interesting about many of the things that emanate from Charlie Munger’s mouth is that they reflect an understanding of deep truths in the world, and these truths often stand the test of time.
Despite that this talk occurred over 20 years ago, we were particularly intrigued by a few aspects related to investment management and value investing.
From Munger’s talk:
…we’re way less diversified. And I think our system is miles better. However, in all fairness, I don’t think a lot of money managers could successfully sell their services if they used our system. But if you’re investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else’s so long as it’s all going to work out well in the end? So what if there’s a little extra volatility?
Munger is referring here to the notion of diworsification and “tracking error.” When you take concentrated, less diversified positions, you are doing something different from the crowd, and your returns are therefore going to be very different from the average – sometimes on the downside. For this reason many are deeply fearful of taking concentrated positions. Yet this is critical if you want to be a successful value investor. The value investing funds – like Munger’s – that perform best over the long run take concentrated positions and don’t hold 100+ stock portfolios.
In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct. That’s the equivalent in investment management to the custom of binding the feet of Chinese women. It’s the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it. That is really hobbling yourself.
Leave it to Charlie Munger to refer to Nietzsche in the context of asset management. What is he driving at?
In “Thus Spoke Zarathustra,” Nietzsche preaches the value of educating yourself, being faithful to yourself, and ignoring convention and the crowd in the marketplace. Munger’s “man with the lame leg” represents this ignorant crowd. In Munger’s view, the man with the lame leg hasn’t fully grasped the truth – that you must do something different to outperform, and accept the implications of that, including a bumpy ride. But as an investor, you shouldn’t care about a bumpy ride!
The man with the lame leg, by contrast, does care, and by god he’s proud of it, but he will stumble as he pursues his goal. What Munger is saying is that if you cannot stomach concentration and the associated volatility, but instead insist on staying close to index, you are hobbling yourself. You will have become the man with the lame leg.
Now, investment managers would say, “We have to be that way. That’s how we’re measured. “And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system’s “bonkers” and draws a lot of talented people into socially useless activity.
Every “rational consumer” should understand this dynamic. The asset management industry is dominated by people like the man with the lame leg. As Munger says, the system is “bonkers.” Why? Because rational consumers should not be led by the man with the lame leg. Yet they often are. Investment managers may preach a value investment philosophy, but why should you pay someone to keep you close to the index? You can get that essentially for free from a low cost investment advisor like Jack Bogle.
I think a select few—a small percentage of the investment managers—can deliver value added. But I don’t think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.
Crucially, it’s not only the investment manager who has to think this way, but also the investor.
So think for yourself. Call your shots and load up by pursuing concentrated strategies that make sense, but embrace tracking error and understand it goes with the territory. Accept that no strategy outperforms every year, so you must stick with it through periods of underperformance.
It’s a strange and difficult calculus, but imperative for long-run outperformance, especially when you are considering a value investing fund.***
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