Establishing Yardsticks

I’m in the process of writing a book and I’m currently on the chapter about Warren Buffett. I don’t want to reveal too much, but the extended blog post is something I’d want to read, so I’ve been having a lot of fun writing it. It gives a different look at some of the greatest (and one of the worst) investors of all time. Anyway, I wanted to share a great snippet from Buffett’s letter to his limited partners in 1961 (emphasis mine).

In the five years from  1957-1961, the partnership’s cumulative return was 251% before fees and 181.6% after, compared with the Dow Jones Industrial Average which gained 74.3%. Coming off such a strong period of outperformance, Buffett wanted to set realistic expectations and establish guidelines for how his partners should judge his results.

A Word About Par

The outstanding item of importance in my selection of partners, as well as in the subsequent relations with them, has been the determination that we use the same yardstick. If my performance is poor, I expect the partners to withdraw, and indeed, I should look for a new source of investment for my own funds. If the performance is good, I am assured of doing splendidly, a state of affairs to which I am sure I can adjust.

The rub, then is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.

I have continuously used the Dow-Jones Industrial Average as our measure of par. It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at lest that long where the terminal level of the Dow is reasonably close to the initial level.

While the Dow is not perfect (nor is anything else) as a measure of performance it has the advantage of being widely known, has a long period of continuity and reflects with reasonable accuracy the experience of investors generally with the market. I have no objection to any other method of measurement of general market performance being used, which as other stock market averages, leading diversified mutual stock funds, bank common trust finds, etc.

You may feel I have established an unduly short yardstick in that it perhaps appears quite simple to do better than an unmanaged index of 30 leading common stocks. Actually, this index has generally proven to be a reasonably tough competitor. Arthur Wiesenberger’s classic book on investment companies lists performance for the 15 years, 1946-1960, for all leading mutual funds, so the experience of these funds represents, collectively, the experience of many million investors. My own belief, though the figures are not obtainable, is that portfolios of some lending investment council organizations and bank trust departments have achieved results similar to these mutual finds.

Wiesenberger lists 70 funds in his “Charts & Statistics” with continuous records since 1946. I have excluded 32 of these funds for various reasons since there were balanced funds (therefore not participating fully in the general market specialized industry funds, etc.) Of the 32 excluded because I felt a comparison would not be fair, 31 did poorer than the Dow, so there were certainly not excluded to slant the conclusions below.

Of the remaining 38 mutual funds whose method of operation I felt was such to make a comparison with the Dow reasonable, 32 did poorer than the Dow, and 6 did better. The 6 doing better at the end of 1960 had assets of about $1 million and the 32 doing poorer had assets of about $6-1/2 billion. None of the six that were superior beat the Dow by more than a few percentage points a year.


Buffett Letters to Partners