The Croupiers' Take: Hidden Costs of Investment Complexity
Munger argues that layers of investment fees, consultants, and trading costs can consume a foundation’s returns. He discusses low-cost indexing and concentrated long-term ownership as different alternatives, and uses a historical three-percent cost estimate to show how fees and donations can shrink assets.
THE IDEA
The Croupiers' Take: Hidden Costs of Investment Complexity
In this speech to foundation financial officers, Charlie Munger critiques the growing complexity and cost of institutional investment management. He notes that many foundations have adopted a 'fund of funds' approach, hiring multiple layers of consultants and investment counselors, which drives up total frictional costs to as much as 3% of net worth per year. This cost is often hidden in conventional accounting.
Munger demonstrates the arithmetic: if average gross real return drops to 5% (from the 17% cited for the period), the croupiers' take of 3% plus a 5% donation leaves an annual shrinkage of 3%. He emphasizes that all equity investors, in aggregate, bear a performance disadvantage equal to total costs, and that half of investors will be below the median.
Overconfidence and Human Nature
Munger links this to cognitive biases: Demosthenes' observation that 'what a man wishes, he will believe' and the Swedish drivers survey (90% consider themselves above average). Investment professionals are even more overconfident. He cites the collapse of Long-Term Capital Management, despite high IQs, as an example of overconfidence leading to disaster. Feynman's advice is key: 'The first principle is that you must not fool yourself—and you're the easiest person to fool.'
Three Options for Foundations
- Indexing: Dispense with consultants, reduce turnover, and invest in low-cost index funds. Munger recommends considering this when total croupier costs exceed 1% per annum.
- Berkshire Hathaway Model: Invest with near-zero turnover in a few admired domestic corporations, keeping total croupier costs below 0.1% per annum.
- Limited Partnerships: Invest in LBO funds, venture capital, or other alternative assets. Munger warns that LBO funds are essentially leveraged equity investments with high fees and increasing competition, and they carry covariance with bad market conditions.
Diversification vs. Concentration
Munger challenges the orthodoxy of huge diversification. He argues that a person or institution with most wealth in just three fine domestic corporations is securely rich. He cites the Woodruff Foundations, which retained ~90% concentration in Coca-Cola stock, and notes that many foundations would be better off never selling founder's stock. Rich institutions should self-insure rather than over-diversify.
Social Consequences
Even if complex strategies worked, they would have antisocial effects by attracting young brainpower into money management rather than productive work. Munger calls early Charlie Munger 'a horrible career model' and advocates for long-term concentrated investment in admired domestic corporations, following Ben Franklin's example.
2006 Revisit
In a later addendum, Munger notes that frictional costs have increased and more young talent is drawn to investment touting, though index investing is slowly growing.
When to use it
A charitable foundation evaluating whether to hire multiple investment consultants or switch to a low-cost index fund.
An individual investor deciding between an actively managed fund with high fees and a passive ETF.
A university endowment considering whether to invest in a fund-of-funds or directly in a few concentrated holdings.
A family office assessing the long-term impact of investment costs on wealth preservation.
FROM THEORY TO EVERYDAY LIFE
In practice
Long-Term Capital Management Collapse
Long-Term Capital Management, founded in 1994 by a respected bond trader and two Nobel laureates, used highly leveraged mathematical models for arbitrage. By 1998, it had $125 billion in debt. A few months of negative returns, combined with Salomon Brothers' exit and foreign panics, led to a loss of $2 billion in capital. The Federal Reserve organized a bailout to prevent systemic liquidity crisis.
General Motors' Four-Door Truck Mistake
General Motors, using fancy consumer surveys, decided not to put a fourth door on a truck designed as a comfortable five-passenger car. Competitors observed that five people regularly enter and exit cars, and that people prefer effort minimization. This overconfident decision cost hundreds of millions of dollars.
Swedish Drivers Survey
A careful survey in Sweden showed that 90% of automobile drivers considered themselves above average, illustrating overconfidence in self-appraisal.
A MOMENT TO REFLECT
Put it to work.
How might overconfidence in your own investment abilities lead to higher costs and lower net returns?
What hidden fees or frictional costs exist in your current investment strategy, and how can you minimize them?
Why do you think many foundations and institutions continue to use complex, high-cost strategies despite evidence that simple indexing often outperforms?
Often confused with
References
- When Genius Failed — Roger Lowenstein (1999)
CONTINUE THE CONVERSATION
Source texts
- Poor Charlie's Almanack