The 40 Percent Rule

The 40 Percent Rule refers to Ground Rule 7 of the Buffett Partnership Ltd. (BPL), which formalizes Warren Buffett's willingness to concentrate capital in a single high-conviction security. It stands as a cornerstone of his early investment philosophy, directly opposing the traditional Wall Street doctrine of broad diversification.

📍 Origin

The rule was formally introduced in the 1965 Letter to Limited Partners as an addition to the partnership's Ground Rules. Prior to 1965, Buffett had operated with high concentration (such as in Sanborn Map Co. or Dempster Mill Manufacturing Co.), but Ground Rule 7 codified this behavior into a contractual agreement.

🧠 The Core Argument

• The Premise: Truly outstanding, low-risk investment opportunities are exceptionally rare. Therefore, when such an opportunity is found, it is illogical to limit its impact by spreading capital across inferior ideas.
• The Mechanism: By concentrating up to 40% of net worth in a single security, the investor maximizes exposure to their highest-conviction idea. This is only done when the probability of being correct is extremely high and the risk of a permanent, structural change in the asset's value is very low.
• The Conclusion: While concentration increases the short-term volatility (amplitude) of the portfolio's market value, it dramatically reduces the risk of permanent capital loss and enhances long-term compounding.

📅 Chronological Evolution

• 1965 Partnership Letter: Buffett formalizes the rule as Ground Rule 7, defending concentration against the institutional "Noah School" of investing.
• 1970 Letter - 1979 Letter: As Buffett transitions BPL's capital into Berkshire Hathaway, he continues the concentration policy. By the late 1970s, Berkshire's equity portfolio is dominated by a few massive positions (e.g., GEICO, Washington Post).
• 1993 Letter: Buffett explicitly contrasts his concentration policy with modern portfolio theory (MPT), arguing that academic definitions of "risk" (volatility) are incorrect. He asserts that a concentrated portfolio of three excellent businesses is far safer than a diversified portfolio of thirty mediocre ones.

🗣️ Primary Source Quotes

"We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment." — Warren Buffett, 1965 Partnership Letter

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying it." — Warren Buffett, 1978 Letter

🔗 Connections

• Related Concepts: The Ground Rules, Overdiversification, Capital Allocation, Margin of Safety
• Related Entities: Sanborn Map Co., Berkshire Hathaway Inc., GEICO
• Key Sources: 1965 Letter, 1978 Letter, 1993 Letter