At a young age of just 25 years old, Warren Buffett had a keen vision on how he would run his partnership and achieve superior returns for investors. He called these principles The Ground Rules, and ensured that his partners, friends and family, agreed to these terms so they could understand Buffett’s vision.
To say that Warren stayed true to his ground rules and used them for great success would be an understatement:
From 1956 to 1969, Warren Buffett recorded a rate of performance for his investors in the Buffett Partnership that is now legendary. For these 13 years, Buffett gained an astounding 24.5% CAGR after fees, turning $105k into over $7 million.
So what were these famous Ground Rules from Warren Buffett? I’ve included the 7 Ground Rules below with some commentary on why I think each were integral to his success as a fund manager.
1. 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.
From the onset, Buffett tries to set expectations and be sincere. There are no guarantees, and anybody who tries to tell you that about investing is lying to you.
What I like about what Warren Buffett did here is that he put himself into the investor’s shoes, and realized that just because he was in the wealth accumulation stage, his partners might not be.
In other words, his partners might want to withdraw capital so that they could have an income from their investment in the Buffett Partnership, and so the 6% goal would allow that while also still growing the partner’s total investment value in the fund.
2. 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.
Luckily this condition was never a problem, but Buffett decided to consider the risks inherent with investing and what would happen on the downside.
The likely reason for this Ground Rule is that the best time to be buying stocks is usually when returns and performance are depressed. Too many partners withdrawing capital would limit Buffett’s ability to attack when the market was down, and limit future performance if/when it recovered.
3. 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 results for tax purposes in a given year.
Another ground rule to set expectations by Buffett here, and he’s simply being transparent about how performance will be measured so that there are no surprises—or chances that Buffett will craft some creative return metric if his investments didn’t perform as he expected.
4. 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 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.
I find this ground rule interesting as it’s slightly controversial. There are many among the active management camp that believe that a manager’s performance should be measured by absolute and not relative performance. I tend to agree with this philosophy, even though there is value in measuring both.
5. 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.
Stating expectations on future performance again, Buffett warns against the possibility that a market exuberance, such as the one seen in the Roaring 20’s, would occur again.
Being a student of Graham’s, Buffett was well aware that the valuations from the stock market can fly wildly above a company’s true intrinsic value, as Mr. Market can sometimes be quite irrational in how he sets prices.
6. 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.
This ground rule is classic Benjamin Graham philosophy. As Graham’s student, Buffett was fully convinced with the stupidity of trying to time the market, and he didn’t want his investors thinking he had any sort of ability to.
It goes back to the theme that is constant in many of Warren Buffett’s ground rules—that expectations need to be set, and they generally needed to be tempered. Luckily for his partners, Buffett wildly outperformed these very modest and humble expectations.
7. I cannot promise results to partners. What I can and do promise is that: a. Our investments will be chosen on the basis of value, not popularity; b. 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 c. my wife, children and I will have virtually our entire net worth invested in the partnership.
In these closing words, Buffett reveals the parts of his investment philosophy that are among what I greatly admire most about him: he was an adamant and unapologetic value investor, and he truly had his interests aligned with the investors in his partnership.
It’s hard to find either of those qualities on today’s Wall Street, which could be why it’s so hard to find active management who are able to follow in Buffett’s footsteps.
Whether you believe that today’s investors can achieve superior returns from the market like Warren Buffett did or not, there’s much to learn and implement behind Warren Buffett’s ground rules that could help any investor—with the way to set expectations and how to think about achieving great returns from the stock market.