I have chosen to adopt these “Ground Rules” for investing. They are taken from a letter Warren Buffet wrote to his clients in 1963 and are still as useful and powerful as they were then.
‘The Ground Rules’
In the 1963 letter, Buffett also laid out seven requirements for his partners, which he called “The Ground Rules.”
In no sense is any rate of return guaranteed to partners. Your interest in the partnership may result in eventual gain or eventual loss and neither I nor anyone else can tell you what the answer is going to be. 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 of year end against how we stood on the same bases at the beginning of the year. This may bear very little relationship to the realized results for tax purpose in a given year.
Whether we do a good job or a poor 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 that 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 years is an absolute minimum for judging performance. It is a 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 the partnership.
I cannot promise results to partners. What I can and do promise 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…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 our entire net worth invested in the partnership.
Buffet repeated his mantra about performance: “Our job,” he wrote, “is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus.” (By late 1967, Buffet, finding fewer bargains, would trim his hoped-for margin of Dow out performance to 5%.)