Conventional investing wisdom says that one needs to concentrate investments when amassing wealth and diversify when preserving wealth. Most successful entrepreneurs at some point have 90+ percent of their wealth tied up in a single company. They are in wealth amassing mode and represent the extreme of asset concentration. Ironically, most entrepreneurs are quite comfortable with their non-diversified assets.

Young people with several decades until retirement mainly want to amass wealth, not preserve it. But how do you do that if you are not an entrepreneur? Charlie Munger points out that the first step to wealth is to spend less than you earn from the outset. As you generate savings, the most logical choices are to invest either in individual stocks or mutual funds or both.

Mutual funds has been one of the most rapidly growing industries for the last two decades. The number of funds has mushroomed to more than 8,000; assets under management have grown consistently to several trillion dollars over the years. This, despite the fact that six out of every seven funds lag the performance of the S&P 500 index over time. The industry is one of the only ones I know of where even if you perform poorly, you still continue to grow revenues and profit!

If the objective is to amass wealth, then mutual funds are not the answer. Regulations do not permit funds to invest more than five percent of assets in a single stock. Thus, at a minimum, any fund has at least 20 stocks. In practice, virtually all mutual funds have hundreds of stocks with no single one being more than two to three percent of the portfolio. Any portfolio with hundreds of securities has a very high probability of under-performing the market and an infinitesimal probability of outperforming it. I find it difficult to find more than four to six winners in a year. I don’t know how a fund manager can find 200 winners. There is very good logic behind the 5 percent rule: it protects investors from big losses. The side effect is that it pretty much guarantees mediocrity.

The best way to sum up mutual fund investing is the following quote from Warren Buffett, taken from the 1996 Annual Report of Berkshire Hathaway:

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