“…I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.”
—Warren Buffett, January 18, 1963
Ground Rules, Partners, and Reasonable Expectations
I am currently reading Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, authored by Jeremy Miller. This book contains, for the first time, a compilation of Warren Buffett’s Partnership letters, and Buffett’s own words written to his partners about his investment principles, for example his view on diversification strategy, compounding interest, preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually. Demonstrating Buffett’s intellectual rigor, they provide a framework to the craft of investing that had not existed before: Buffett built upon the quantitative contributions made by his famous teacher, Benjamin Graham, demonstrating how they could be applied and improved.
I have read the Buffett Partnership Letters before, and they are well worth reading. In one of the letters, dated January 18, 1963, Buffett lays out his “Ground Rules.” These rules provide a great example of how to make sure that partners have reasonable expectations about what results could be expected from the Partnership itself, and Buffett himself as the sole investment manager. For this reason I wanted to put the rules up on the blog to keep them with me on my investing journey.
“The Ground Rules” written by Buffett in a letter to his partners in the beginning of 1963 are as follows.
The Ground Rules
Some partner have confessed (that’s the proper word) that they sometimes find it difficult to wade through my entire annual letter. Since I seem to be getting more long-winded each year, I have decided to emphasize certain axioms on the first page. Everyone should be entirely clear on these points. To most of you this material will seem unduly repetitious, but I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.
- In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that—withdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital.
- Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.
- Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
- Whether we do a good job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
- While I much prefer a five-year test, I feel three year is an absolute minimum for judging performance. It is certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
- I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in my partnership.
- I cannot promise results to partners. What I can do is that:
- Our investments will be chosen on the basis of value, not popularity;
- That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments, and
- My wife, children and I will have virtually out entire net worth invested in the partnership.
To read the full Buffett Partnership letter quoted above, click here.
To read a sample from the book Warren Buffett’s Ground Rules, click here.
3 thoughts on “Warren Buffett’s Ground Rules”
The partnership was based on so simple principles, and with a so simple structure. No major incentive misalignments or agency problems. Yet so few on Wall Street (or anywhere else) is copying the model, instead sticking to “2-and-20” and similar models that doesn’t even begin to align the interests of the investor with those of the manager.
Totally agree. But as Jim Chanos said in his most recent interview with FT Alphachatterbox: “It’s awfully hard to beat the market.” A big chunk of the fees (or pretty much all of it) would just go away for most of the 2/20 funds, at least those not generating any excess returns, i.e., beating the market index.
Good point. It’s not a simple problem to solve, but it keeps the wrong people overpaid and gives the wrong incentives (i.e increase AUM instead of focusing on performance). High-water marks at least help reduce the problem, but I’m not sure how widespread they are. Sometimes I have a very hard time understanding that anyone would invest in a 2/20 fund, unless the manager has an exceptional track record.