Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. For any business, tapping the right client base and keeping those clients happy is crucial. To do so, Buffett believed in the establishment of mutually agreed upon objectives, and keeping his clients abreast of any changes in those objectives.

In 1967, change was indeed in the air. In the passages below, Buffett candidly discusses the rationale and impact of these changes (in both his personal life and the market) with his clients. Such behavior in the investment management industry is rather rare, simply because it risks torpedoing an existing (and very lucrative) business model.

Clients

“…some evolutionary changes in several ‘Ground Rules’ which I want you to have ample time to contemplate before making your plans for 1968. Whereas the Partnership Agreement represents the legal understanding among us, the ‘Ground Rules’ represent the personal understanding and in some way is the more important document.”

“Over the past eleven years, I have consistently set forth as the BPL investment goal an average advantage in our performance of ten percentage points per annum in comparison with the Dow…The following conditions now make a change in yardsticks appropriate:

The market environment has changed progressively over the past decade, resulting in a sharp diminution in the number of obvious quantitative based investment bargains available;
Mushrooming interest…has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value;
The enlargement of our capital base to about $65 million when applied against a diminishing trickle of good investment ideas has continued to present…problems…;
My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.

“In my opinion what is resulting is speculation on an increasing scale. This is hardly a new phenomenon; however, a dimension has been added by the growing ranks of professional…investors who feel they must ‘get aboard’…To date it has been highly profitable…Nevertheless, it is an activity at which I am sure I would not do particularly well…It represents an investment technique whose soundness I can neither affirm nor deny. It does not completely satisfy my intellect (or perhaps my prejudices), and most definitely does not fit my temperament. I will not invest my own money based upon such an approach – hence, I will most certainly not do so with your money.

Any form of hyper-activity with large amounts of money in securities markets can create problems for all participants. I make no attempt to guess the actions of the stock market…Even if there are serious consequences results from present and future speculative activity, experience suggests estimates of timing are meaningless…

The above may simply be ‘old fogeyism’ (after all, I am 37). When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially, I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”

Psychology, Benchmark

“The final, and most important, consideration concerns personal motivation. When I started the partnership I set the motor that regulated the treadmill at ‘ten points better than the Dow.’ I was younger, poorer and probably more competitive. Even without the three previously discussed external factors making for poorer performance [see bullet points at top], I would still feel that changed personal conditions make it advisable to reduce the speed of the treadmill…

Elementary self-analysis tells me that I will not be capable of less than all-out effort to achieve a publicly proclaimed goal to people who have entrusted their capital to me. All-out effort makes progressively less sense…This may mean activity outside the field of investments or it simply may mean pursuing lines within the investment field that do not promise the greatest economic reward. An example of the latter might be the continued investment in a satisfactory (but far from spectacular) controlled business where I like the people and the nature of the business even though alternative investments offered an expectable higher rate of return. More money would be made buying businesses at attractive prices, then reselling them. However, it may be more enjoyable (particularly when the personal value of incremental capital is less) to continue to own them and hopefully improve their performance, usually in a minor way…

Specifically, our longer term goal will be to achieve the lesser of 9% per annum or a five percentage point advantage over the Dow. Thus, if the Dow averages -2% over the next five years, I would hope to average +3% but if the Dow averages +12%, I will hope to achieve an average of only 9%. These may be limited objectives, but I consider it no more likely that we will achieve even these more modest results under present conditions than I formerly did that we would achieve our previous goal of a ten percentage point average annual edge over the Dow.”

Shifting personal goals and life decisions can materially impact future returns.

Time Management

“When I am dealing with people I like, in businesses I find stimulating (what business isn’t), and achieving worthwhile overall returns on capital employed (say, 10-12%) it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.”

We’ve heard of the concept of risk-adjusted return. But what about time or aggravation-adjusted return?