Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor

by Jeremy C. Miller

They make a powerful argument for a long-term value-oriented strategy, one that is especially viable in turbulent times such as our own, when people are vulnerable to a speculative, oftentimes leveraged, short-term focus that is rarely effective in the long run. They provide timeless principles of conservatism and discipline that have been the cornerstone of Buffett’s success.

It’s an attitude-over-IQ approach—staying true to one’s process without getting drawn in by the trends is one of the hardest things for even the most seasoned investors.

We can see various patterns emerge over multiple letters where he’s revisiting certain ideas and track the progression of his thinking, something that can be more difficult to pick up on when the letters are read chronologically.

“The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it.”

I like to think of this book, in its own way, as a re-creation of that early “Investing Principles” class, drawing on the lessons he taught in the Partnership Letters that were written during the very time this course was offered.

It’s your annotated guide to the basics of intelligent investing, as told through the key excerpts from almost forty of these early letters. These were the pre-Berkshire years, 1956 to 1970, a time when his capital was modest and his opportunity set was unbounded. It was a time, especially in the early days of the Partnership, when he was most like you and me in that he was able to invest in nearly everything, when no companies were too small for him to be interested.

There is no better place to start a book on basic intelligent investing than with the foundational tenet of Buffett’s general thinking, one that’s universally shared by Graham’s disciples: The market can and will at times be completely deranged and irrational in the short term, but over the long term it will price securities in line with their underlying intrinsic values.

what we’re actually after as investors: consistently sound, rational business analysis based on logic and good reasoning that leads to the selection of securities offering the highest potential return with the lowest possible amount of corresponding risk. That’s the long-term investor’s approach, and it’s a very different approach from trying to generate gains by speculating on what other investors will or will not do or by making guesses around short-term changes in macro variables like oil prices or interest rates.

Over the long term, however, markets do tend to get it right and ultimately reflect the economic experience of a business into the price of its stock. Knowing this, investors therefore focus on solid long-term business analysis and conservative reasoning—that’s what we believe leads to above-average results over time.

Grasping Buffett’s investing principles, the part that’s remained constant from the Partnership years all the way through to the present day, requires a firm understanding of several of Graham’s foundational ideas and influences.

Viewing the market through the lens of Graham’s allegory reveals why the market price on any given day should not inform our view of a security’s underlying intrinsic value. We must arrive at that figure independently and then only act when Mr. Market’s mood is in our favor.

If you rely on the market’s price to value a business, you’re apt to miss opportunities to buy at times when he’s depressed and sell when he’s manic. You can’t let the market do your thinking for you. Investors know they have to do their own work.

The “work,” of course, is the appraisal of business value. While short-term prices may be at the mercy of Mr. Market’s mood, over the long term a stock is going to approximately track the underlying intrinsic value of the business.

Or as Graham put it: “In the short term, the market is like a voting machine, but in the long term, it’s more like a weighing machine.” This is true because a stock, by definition, is a fractional ownership claim on an entire company. If we can value the business, we can value the stock.

That is why investors play for the long term. We learn through Buffett’s teaching to focus our efforts on the business, not the short-term timing of when sound investments are likely to pay off. As Buffett wrote, “The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”

This idea is consistently stressed throughout the letters so I’ll stress it again here: Stocks are not just pieces of paper to be traded back and forth, they are claims on a business, many of which can be analyzed and evaluated. If market prices of businesses (stocks) move below intrinsic values for any extended period of time, market forces will eventually act to correct the undervaluation because in the long term, the market is efficient.

“When” is not the relevant question because it’s dependent on “Mr. Market,” who is not reliable.

It’s hard to know at the time of purchase what’s going to get him to wake up to the value you might see as being plainly there. However, companies often buy back their stock when they recognize it’s cheap. Larger companies and private equity firms often look to acquire undervalued companies in their entirety. Market participants, aware of the potential for all of th...

Buffett teaches investors to trust that the market will get it right eventually; he focuses us on finding the right businesses at the right prices, largely ignoring the timing of when t...

One need only turn on the television to see these market pundits, all seemingly following Lord Keynes’s derisive advice: “If you can’t forecast well, forecast often.”

According to Buffett, predictions often tell you more about the forecaster than they do about the future.

Who would sell a farm because they thought there was at least a 65% chance the Fed was going to raise rates next year?

A good deal of Buffett’s astonishing success during the Partnership years and beyond has come from never pretending to know things that were either unknowable or unknown.

The market is inevitably going to slump into truly dour moods from time to time—very little can typically be done to avoid getting caught in the downdrafts. Buffett reminds investors that during such periods even a portfolio of extremely cheap stocks is likely to decline with the general market. He stresses this as an inevitable part of owning securities and that if a 50% decline in the value of your securities portfolio is going to cause you hardship, you need to reduce your exposure to the market.

The good news is that the occasional market drop is of little consequence to long-term investors. Preparing yourself to shrug off the next downturn is an important element of the method Buffett lays out.

Since the general trend is up, as long as a severe 25–40% drop isn’t going to somehow cause you to sell out at the low prices, you’re apt to do pretty well in stocks over the long run. You can allow the market pops and drops to come and go, as they inevitably will.

While most investors were selling when the market outlook became worrisome or even cloudy, those who ignored market sell-offs (or forgot they were invested at all) did vastly better. This is a great example: To be a successful investor, you need to separate your emotional reaction to a plunge from your cognitive ability as a rational appraiser of long-term business value. You can never let the market quote turn from an asset to a liability.

my own investment philosophy has developed around the theory that prophecy reveals far more of the frailties of the prophet than it reveals of the future.

We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do.

The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right.

In the words of the poet—Harry Truman—“If you can’t stand the heat, stay out of the kitchen.”

Thinking of ourselves now as investors, we come to understand short-term fluctuations in securities prices are often driven by swings in market psychology, but over multiyear periods investing results will be determined by the underlying fundamental results of the businesses we own and the prices we paid.

Market swoons are inevitable, and since we can’t predict their timing we accept them as our price of admission as investors.

Einstein is said to have called compound interest the eighth wonder of the world and said that “those who understand it, earn it, and those who don’t, pay it.”

At its very root, an investment program is first and foremost a compounding program. It is the process of continuously reinvesting gains such that each subsequent addition begins earning a return itself. These gains on gains become an increasingly dominant component of an investment program’s total returns over time.

as investors, we allow our gains to pile up upon themselves as the primary driver of our wealth creation. We do it patiently.

Compounding’s importance is hard to overstate. It explains why Charlie Munger, Buffett’s friend in the Partnership years and current vice chairman of Berkshire, once said Buffett viewed a $10 haircut like it was actually costing him $300,000. Turns out he was only modestly conservative; a $10 haircut skipped by Buffett in 1956 and instead invested in

the Partnership would be worth more than $1 million today ($10 compounded at 22% for 58 years). Viewed through Buffett’s compound interest lens, it’s not hard to see why he has lived suc...

Buffett has resided in the same house for decades. His approach to life and investing is pragmatic and fulfilling. His patience and frugality have allowed him to keep the maximum amount of funds invested and compounding.

Notice the huge advantage financially from a long investment life and the huge advantage that comes with a high rate of return. If you can combine the two factors, the results are eye-popping:

(1) Compounding is equally sensitive to changes in time as it is to changes in rate, and (2) seemingly insignificant changes in rate really add up when viewed through the lens of a long-term investment program.

Investors take the long view and think of stocks as fractional ownership claims on businesses. They don’t get spooked by the market swings and avoid fees and taxes to the fullest extent practical. They harness the parabolic nature of long-term compound interest, at the highest rate for the

longest period of time possible—it’s your primary tool as an investor.

In addition to Graham’s lesson—that stocks are businesses and the market is there to serve, not inform—we now have another mantra: “Investment decisions should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.”

Today, investors can harness this power by simply owning the entire market through a low-cost index fund. This is one of the best strategies going. It’s the “do-nothing” approach. Its main benefit, aside from working so well, is that it’s cheap and easy to implement on your own. You certainly don’t need to pay anyone a big fee to tell you to just buy the market, sit back, and latch on to the power of compounding.

So far, Buffett’s lessons from the letters have revolved around six key ideas for all investors: Think of stocks (1) as fractional claims on entire businesses, (2) that swing somewhat erratically in the short term but (3) behave more in line with their gains in intrinsic business value over the longer term, which, when (4) viewed through the lens of a long-term compounding program (5) tend to produce pretty good results, which, with (6) an index product, can be captured efficiently in a low-cost, easy-to-implement way.

Poor measurement, in Buffett’s view, is a dangerous investment sin. He sets two fundamental rules to (a) establish the measurement “how,” which is based on a relative-to-market-performance test, and then (b) establish the measurement “how long,” which

sets forth the minimum span over which an investment operation can be judged.

1. Ground Rule #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.”3