Warren Buffett on Market Psychology

At the 2024 Berkshire annual meeting, the first after Charlie Munger's death in November 2023, I told the audience that the partnership with Charlie had been the most fortunate thing in my life, after my family. The mistakes-and-learning discussion was, in this sense, the most poignant I had ever given. I told the audience that the biggest lesson Charlie had taught me, over six decades of partnership, was the willingness to acknowledge my own mistakes promptly, and to apply the lessons without sentiment. Charlie had been the most relentless truth-teller I had ever known, and his gift was not flattery; it was the willingness to tell me, in front of others, when I was wrong. The lesson I tried to convey was that the disciplined investor must find a truth-teller, must listen to him, and must be willing to act on what he hears, even when the action is uncomfortable, especially when the action is uncomfortable. The capital-allocation-discipline discussion at the 2024 meeting was, in some ways, the most candid I had given. I told the audience that the biggest mistake of the previous decade had been the refusal to buy certain wonderful businesses when they were cheap, on the grounds that I did not understand them well enough. The opportunity cost of those refusals was, in dollar terms, very large. The lesson I tried to convey was that the disciplined investor must be willing to update his circle of competence when the evidence warrants, and to acknowledge that a business he once refused to buy has, in retrospect, become something he should have owned. The investor who refuses to update his circle of competence, on the grounds that consistency is a virtue, eventually outlives his own circle, and the market leaves him behind. Charlie had been the one who most often pushed me to update. The market-psychology point I tried to add was that the previous fifteen years had been unusual, in that interest rates had been kept at or near zero for most of that period, and that the easy money had pushed asset prices to levels that, in normal-rate environments, would have been unsustainable. The investor who recognised that the zero-rate regime was temporary, and who positioned his portfolio for a return to normal rates, had an enormous advantage over the investor who assumed that zero rates were permanent. The 2024 meeting was, in many ways, a summing-up. I told the audience that the lessons I had learned in six decades of investing, with Charlie at my side for most of them, were the same lessons I had learned in the first decade: buy wonderful businesses, hold them for a long time, refuse to be panicked out by short-term volatility, and never forget that the long run is the only horizon that matters for the investor with the right temperament and a strong balance sheet.

The 2023 Berkshire meeting was the last one at which Charlie Munger sat beside me on stage. I told the audience that the partnership with Charlie had been the most fortunate thing in my life, after my family. The mistakes-and-learning discussion was, as always, the most useful part of the meeting. I told the audience that the biggest mistakes of the previous decade had been mistakes of omission, not commission. There were several wonderful technology businesses that I had studied carefully, understood reasonably well, and failed to buy when they were cheap. Charlie had told me to buy them. I had refused, on the grounds that I did not understand them well enough. The opportunity cost of those refusals was, in dollar terms, very large. The lesson I tried to convey was that the disciplined investor must be honest with himself about which refusals were wise and which were stubborn, because the line between the two is not always clear at the time. The market-psychology discussion at the 2023 meeting was unusually candid. I told the audience that the previous fifteen years had been unusual, in that interest rates had been kept at or near zero for most of that period. That single fact had pushed asset prices to levels that, in normal-rate environments, would have been unsustainable. The investor who recognised that the zero-rate regime was temporary, and who positioned his portfolio for a return to normal rates, had an enormous advantage over the investor who assumed that zero rates were permanent. The capital-allocation-discipline lesson was that the investor who buys wonderful businesses at reasonable prices, and who refuses to chase the prices that zero rates had temporarily supported, has the long run on his side. The investor who chased the prices, on the assumption that zero rates would last forever, has learned, painfully, that asset prices are bounded by the cash those assets will eventually distribute to their owners. The capital-allocation-discipline lesson I have repeated most often in the last decade is that the investor who buys a wonderful business at a fair price will outperform the investor who buys a mediocre business at a wonderful price. The reason is that the wonderful business compounds its earnings at a high rate, and the compounding, over decades, dwarfs the entry-price advantage. The mediocre business, even bought cheaply, does not compound its earnings, and the entry-price advantage erodes quickly. The 2023 meeting was, in many ways, a summing-up. I told the audience that the lessons I had learned in six decades of investing were the same lessons I had learned in the first decade: buy wonderful businesses, hold them for a long time, refuse to be panicked out by short-term volatility, and never forget that the long run is the only horizon that matters for the investor with the right temperament and a strong balance sheet.

Our goal is realistic. Berkshire’s strength comes from its Niagara of diverse earnings delivered after interest costs, taxes and substantial charges for depreciation and amortization (“EBITDA” is a banned measurement at Berkshire). We also operate with minimal requirements for cash, even if the country encounters a prolonged period of global economic weakness, fear and near-paralysis. Berkshire does not currently pay dividends, and its share repurchases are 100% discretionary. Annual debt maturities are never material. Your company also holds a cash and U.S. Treasury bill position far in excess of what conventional wisdom deems necessary. During the 2008 panic, Berkshire generated cash from operations and did not rely in any manner on commercial paper, bank lines or debt markets. We did not predict the time of an economic paralysis but we were always prepared for one. Extreme fiscal conservatism is a corporate pledge we make to those who have joined us in ownership of Berkshire. In most years – indeed in most decades – our caution will likely prove to be unneeded behavior – akin to an insurance policy on a fortress-like building thought to be fireproof. But Berkshire does not want to inflict permanent financial damage – quotational shrinkage for extended periods can’t be avoided – on Bertie or any of the individuals who have trusted us with their savings. Berkshire is built to last.

For a long time, the pessimism appeared to be correct, with production falling to five million BOEPD by 2007. Meanwhile, the U.S. government created a Strategic Petroleum Reserve (“SPR”) in 1975 to alleviate – though not come close to eliminating – this erosion of American self-sufficiency. And then – Hallelujah! – shale economics became feasible in 2011, and our energy dependency ended. Now, U.S. production is more than 13 million BOEPD, and OPEC no longer has the upper hand. Occidental itself has annual U.S. oil production that each year comes close to matching the entire inventory of the SPR. Our country would be very – very – nervous today if domestic production had remained at five million BOEPD, and it found itself hugely dependent on non-U.S. sources. At that level, the SPR would have been emptied within months if foreign oil became unavailable. Under Vicki Hollub’s leadership, Occidental is doing the right things for both its country and its owners. No one knows what oil prices will do over the next month, year, or decade. But Vicki does know how to separate oil from rock, and that’s an uncommon talent, valuable to her shareholders and to her country. * * * * * * * * * * * * Additionally, Berkshire continues to hold its passive and long-term interest in five very large Japanese companies, each of which operates in a highly-diversified manner somewhat similar to the way Berkshire itself is run.

They sometimes command ridiculously higher prices than justified but are almost never available at bargain valuations. Unless under duress, the owner of a controlled business gives no thought to selling at a panic-type valuation. * * * * * * * * * * * * At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. (Remember our escapes from near-disasters at USAir and Salomon? I certainly do.) Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire. Let’s take a peek behind the curtain. The Secret Sauce In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire. The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.

The 2020 Berkshire meeting was held virtually in May, in the early weeks of the pandemic shutdown. I told the audience that I had never seen anything like the speed of the economic collapse, and that I did not know how long it would last. What I knew was that the prices being offered for wonderful American businesses were attractive, and that the long-run outlook for those businesses had not changed. The market-psychology lesson was that the investor who panicked during the March 2020 crash and sold at the bottom had locked in losses that would take years to recover. The investor who held on, or who bought during the panic, owned businesses whose long-run cash flows had barely been dented by the shutdown. The discipline required was patience, and the resource required was a balance sheet strong enough to absorb the short-term paper losses without being forced to sell. The crisis-response discussion at the 2020 meeting was, in some ways, more candid than in past years. I told the audience that Berkshire had not been a major buyer during the March crash, because the prices had rebounded before we could deploy significant capital. That was, in retrospect, a mistake. We had positioned the balance sheet for a prolonged crisis, and when the crisis turned out to be shorter than expected, we had not deployed as aggressively as the situation warranted. The lesson I drew was that even an investor with the resources of Berkshire can be too cautious during a fast-recovering crisis, because the speed of the rebound catches even the patient buyer off guard. The correction is to commit capital more aggressively during the panic phase, accepting that some of those commitments will be early and that the prices may go lower before they go higher. The mistakes-and-learning part of the 2020 meeting was, as always, the most useful. I told the audience that the biggest mistake Berkshire had made during the pandemic was not buying more when the prices were at their lows. The opportunity cost of that hesitation was, in dollar terms, very large. The lesson I tried to convey was that the disciplined investor must be willing to act during a crisis, even when the outlook is unclear, even when the prices may go lower before they go higher. The investor who waits for clarity misses the move. The investor who acts when the headlines are still terrifying, who buys wonderful businesses at panic prices, and who refuses to sell during the early volatility, has an enormous long-run advantage. That is the lesson I have repeated most often in my six decades of investing, and it is the lesson that I expect to repeat as long as I am able.

At the 2018 Berkshire annual meeting, I was asked about the recent write-down at Kraft Heinz, in which Berkshire's stake had declined substantially in value. I told the audience that the write-down was, in part, a recognition that the prices Berkshire had paid for the stake had been too high, and that the underlying business had not performed as well as I had hoped. The mistakes-and-learning lesson I tried to convey was that the disciplined investor must be willing to acknowledge when he has paid too much, and to take the write-down promptly rather than nursing the position in the hope that the price would recover. The capital-allocation-discipline lesson was that the investor who overpays for a wonderful business, even a wonderful business, will, in the long run, underperform the investor who pays a reasonable price for the same wonderful business. The price matters, even when the business is wonderful. The market-psychology discussion at the 2018 meeting was, as always, the most useful part. I told the audience that the previous ten years had been unusual, in that interest rates had been kept at or near zero for most of that period, and that the low rates had pushed asset prices to levels that, in normal-rate environments, would have been unsustainable. The investor who recognised that the zero-rate regime was temporary, and who positioned his portfolio for a return to normal rates, had an enormous advantage over the investor who assumed that zero rates were permanent. The capital-allocation-discipline lesson was that the investor who buys wonderful businesses at reasonable prices, and who refuses to chase the prices that zero rates had temporarily supported, has the long run on his side. The investor who chased the prices, on the assumption that zero rates would last forever, has learned, painfully, that asset prices are bounded by the cash those assets will eventually distribute to their owners. The mistakes-and-learning point I tried to add was that the investor who is honest about his mistakes, including the mistakes he made when the prices were too high, learns far more than the investor who insists that the prices will recover. The Kraft Heinz write-down was, in this sense, a useful discipline. It forced me to acknowledge that I had paid too much, and to apply the lesson the next time. The lesson I tried to convey was that the disciplined investor must be willing to take write-downs promptly, to acknowledge his mistakes, and to apply the lessons. The investor who refuses to acknowledge his mistakes, on the grounds that consistency is a virtue, never learns, and he keeps repeating them at progressively larger scale, until the cost of the mistakes becomes existential. The 2018 meeting was, in some ways, a meditation on the price of stubbornness. The disciplined investor is willing to be wrong, to admit it, and to move on.

Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%! Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To “protect” yourself, you might have eschewed stocks and opted instead to buy 3 1⁄4 ounces of gold with your $114.75. And what would that supposed protection have delivered? You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle. Our country’s almost unbelievable prosperity has been gained in a bipartisan manner. Since 1942, we have had seven Republican presidents and seven Democrats. In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home values, a paralyzing financial panic and a host of other problems. All engendered scary headlines; all are now history. Christopher Wren, architect of St. Paul’s Cathedral, lies buried within that London church. Near his tomb are posted these words of description (translated from Latin): “If you would seek my monument, look around you.

At the 2017 Berkshire annual meeting, I was asked about the recent run-up in technology stocks and the renewed enthusiasm for innovative businesses. I told the audience that the prices being paid for some of the most popular technology businesses had begun to reflect the assumption that the businesses would grow at unprecedented rates forever, and that the assumption was, in my view, optimistic. The market-psychology point I tried to convey was that the crowd, in its optimistic phase, convinces itself that the rules of valuation have been suspended by the new technology. They have not. What has been suspended is only the willingness of investors to enforce the rules. The capital-allocation-discipline lesson was that the investor who recognised the suspension, and who refused to pay the prices that the suspension had produced, had a long-run advantage over the investor who chased the prices on the assumption that the new technology had repealed the old rules of valuation. The mistakes-and-learning discussion at the 2017 meeting was, as always, the most useful part. I told the audience that the biggest mistake of the previous decade had been my refusal to buy certain wonderful technology businesses that I had studied carefully and understood reasonably well. Charlie had told me to buy them. I had refused, on the grounds that I did not understand them well enough. The opportunity cost of those refusals was, in dollar terms, very large. The lesson I tried to convey was that the disciplined investor must be willing to update his circle of competence when the evidence warrants, and to acknowledge that a business he once refused to buy has, in retrospect, become something he should have owned. The investor who refuses to update his circle of competence, on the grounds that consistency is a virtue, eventually outlives his own circle, and the market leaves him behind. The capital-allocation-discipline point I tried to add was that the investor who buys a wonderful business at a reasonable price will outperform the investor who buys a mediocre business at a wonderful price. The reason is that the wonderful business compounds its earnings at a high rate, and the compounding, over decades, dwarfs the entry-price advantage. The mediocre business, even bought cheaply, does not compound its earnings, and the entry-price advantage erodes quickly. The 2017 meeting was, in some ways, a meditation on the tension between consistency and adaptability. The investor who is consistent in his temperament, but adaptable in his circle of competence, has the best of both worlds. The investor who is consistent in his refusal to update, on the grounds that consistency is a virtue, eventually finds that the market has moved on, and his consistency has become a prison. The lesson I tried to convey was that the disciplined investor must be consistent in temperament and adaptable in subject matter.

In a 2017 Fortune piece titled Warren Buffett Gives America a Grade, I argued that the long-run health of the American economy had been, and would remain, the single most important fact in the life of any American investor. The country, despite its periodic crises, had produced per-capita real GDP growth of roughly two percent a year for the previous century. That single fact, compounded over a working life of forty years, had produced a roughly doubling of the standard of living for every generation of Americans. The capital-allocation-discipline lesson I tried to convey was that the investor who bet against the long-run health of the American economy, by going to cash during the panics, by shorting the market during the recoveries, or by chasing the bubbles, had paid a very large cumulative price for his lack of faith. The investor who held on, through every panic and every bubble, had captured the two-percent growth plus the dividend yield. The market-psychology lesson was the one I had repeated most often. The American economy, in its long run, had been remarkably stable, but in its short run, it had been remarkably volatile. The volatility, I argued, was the price the patient investor paid for the long-run returns, and the impatient investor, who tried to time the volatility, almost always underperformed the patient investor who ignored it. The market-psychology point I tried to convey was that the American investor, in his better moments, recognised the long-run stability of the economy and ignored the short-run volatility of the market. In his worse moments, he did the opposite: he extrapolated the short-run volatility into the long run, and he sold at the worst possible moment. The investor with the temperament to hold on through the volatility, and to buy more during the panics, had an enormous long-run advantage over the investor who chased the headlines. The mistakes-and-learning element was the one most readers missed. I had made my share of mistakes, and the Fortune piece gave me an opportunity to acknowledge them. The biggest mistake of the previous decade, I wrote, was a mistake of omission: I had failed to buy two wonderful technology businesses that I had understood reasonably well, because I had been stubborn about the price. The opportunity cost of that stubbornness, in dollar terms, was very large. The lesson I tried to convey was that the disciplined investor must be willing to acknowledge his mistakes, including his mistakes of omission, and to apply the lesson the next time. The investor who refuses to acknowledge his mistakes never learns, and he keeps repeating them at progressively larger scale. The investor who acknowledges his mistakes, writes them down, and applies the lesson, eventually outperforms the investor with the higher IQ who refuses to admit he was wrong.

Dealing from strength is one of Berkshire’s enduring advantages. Kevin Clayton has again delivered an industry-leading performance at Clayton Homes, the second-largest home builder in America. Last year, the company sold 34,397 homes, about 45% of the manufactured homes bought by Americans. In contrast, the company was number three in the field, with a 14% share, when Berkshire purchased it in 2003. Manufactured homes allow the American dream of home ownership to be achieved by lower-income citizens: Around 70% of new homes costing $150,000 or less come from our industry. About 46% of Clayton’s homes are sold through the 331 stores we ourselves own and operate. Most of Clayton’s remaining sales are made to 1,395 independent retailers. Key to Clayton’s operation is its $12.8 billion mortgage portfolio. We originate about 35% of all mortgages on manufactured homes. About 37% of our mortgage portfolio emanates from our retail operation, with the balance primarily originated by independent retailers, some of which sell our homes while others market only the homes of our competitors. Lenders other than Clayton have come and gone. With Berkshire’s backing, however, Clayton steadfastly financed home buyers throughout the panic days of 2008-2009. Indeed, during that period, Clayton used precious capital to finance dealers who did not sell our homes.

Mortgage-origination practices are of great importance to both the borrower and to society. There is no question that reckless practices in home lending played a major role in bringing on the financial panic of 2008, which in turn led to the Great Recession. In the years preceding the meltdown, a destructive and often corrupt pattern of mortgage creation flourished whereby (1) an originator in, say, California would make loans and (2) promptly sell them to an investment or commercial bank in, say, New York, which would package many mortgages to serve as collateral for a dizzyingly complicated array of mortgage-backed securities to be (3) sold to unwitting institutions around the world. As if these sins weren’t sufficient to create an unholy mess, imaginative investment bankers sometimes concocted a second layer of sliced-up financing whose value depended on the junkier portions of primary offerings. (When Wall Street gets “innovative,” watch out!) While that was going on, I described this “doubling-up” practice as requiring an investor to read tens of thousands of pages of mind-numbing prose to evaluate a single security being offered. Both the originator and the packager of these financings had no skin in the game and were driven by volume and mark-ups. Many housing borrowers joined the party as well, blatantly lying on their loan applications while mortgage originators looked the other way. Naturally, the gamiest credits generated the most profits.

Smooth Wall Street salesmen garnered millions annually by manufacturing products that their customers were unable to understand. (It’s also questionable as to whether the major rating agencies were capable of evaluating the more complex structures. But rate them they did.) Barney Frank, perhaps the most financially-savvy member of Congress during the panic, recently assessed the 2010 Dodd-Frank Act, saying, “The one major weakness that I’ve seen in the implementation was this decision by the regulators not to impose risk retention on all residential mortgages.” Today, some legislators and commentators continue to advocate a 1%-to-5% retention by the originator as a way to align its interests with that of the ultimate lender or mortgage guarantor. At Clayton, our risk retention was, and is, 100%. When we originate a mortgage we keep it (leaving aside the few that qualify for a government guarantee). When we make mistakes in granting credit, we therefore pay a price – a hefty price that dwarfs any profit we realized upon the original sale of the home. Last year we had to foreclose on 8,444 manufactured-housing mortgages at a cost to us of $157 million. The average loan we made in 2015 was only $59,942, small potatoes for traditional mortgage lenders, but a daunting commitment for our many lower-income borrowers.

Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket). The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead. With this tailwind working for us, Charlie and I hope to build Berkshire’s per-share intrinsic value by (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares. Those building blocks rest on a rock-solid foundation. A century hence, BNSF and Berkshire Hathaway Energy will still be playing vital roles in our economy.

During the financial panic of 2008 and 2009, when funding for the industry dried up, Clayton was able to keep lending because of Berkshire’s backing. In fact, we continued during that period to finance our competitors’ retail sales as well as our own. Many of Clayton’s borrowers have low incomes and mediocre FICO scores. But thanks to the company’s sensible lending practices, its portfolio performed well during the recession, meaning a very high percentage of our borrowers kept their homes. Our blue-collar borrowers, in many cases, proved much better credit risks than their higher-income brethren. At Marmon’s railroad-car operation, lease rates have improved substantially over the past few years. The nature of this business, however, is that only 20% or so of our leases expire annually. Consequently, improved pricing only gradually works its way into our revenue stream. The trend, though, is strong. Our 105,000-car fleet consists largely of tank cars, but only 8% of those transport crude oil. One further fact about our rail operation is important for you to know: Unlike many other lessors, we manufacture our own tank cars, about 6,000 of them in a good year. We do not book any profit when we transfer cars from our manufacturing division to our leasing division. Our fleet is consequently placed on our books at a “bargain” price.

* * * * * * * * * * * * One more confession and then I’ll go on to more pleasant topics: Can you believe that in 1975 I bought Waumbec Mills, another New England textile company? Of course, the purchase price was a “bargain” based on the assets we received and the projected synergies with Berkshire’s existing textile business. Nevertheless – surprise, surprise – Waumbec was a disaster, with the mill having to be closed down not many years later. And now some good news: The northern textile industry is finally extinct. You need no longer panic if you hear that I’ve been spotted wandering around New England.

Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable. Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer. We have not, for some years, written these contracts, except for a few needed for operational purposes at our utility businesses. Moreover, we will not write insurance contracts that give policyholders the right to cash out at their option. Many life insurance products contain redemption features that make them susceptible to a “run” in times of extreme panic. Contracts of that sort, however, do not exist in the property-casualty world that we inhabit. If our premium volume should shrink, our float would decline – but only at a very slow pace. The reason for our conservatism, which may impress some people as extreme, is that it is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does.

This weird accounting, you should understand, instantly increased Berkshire’s excess of intrinsic value over book value by the same $1.8 billion. Š Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America. Š In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it. I must again confess that their investments outperformed mine. (Charlie says I should add “by a lot.”) If such humiliating comparisons continue, I’ll have no choice but to cease talking about them. Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins. Š Berkshire’s yearend employment – counting Heinz – totaled a record 330,745, up 42,283 from last year. The increase, I must admit, included one person at our Omaha home office. (Don’t panic: The headquarters gang still fits comfortably on one floor.) Š Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of Wells Fargo (increasing our ownership to 9.2% versus 8.

Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments. Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse. A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy. During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well.

The derivatives we have sold that provide credit protection for corporate bonds will all expire in the next year. It’s now almost certain that our profit from these contracts will approximate $1 billion pre-tax. We also received very substantial sums upfront on these derivatives, and the “float” attributable to them has averaged about $2 billion over their five-year lives. All told, these derivatives have provided a more-than-satisfactory result, especially considering the fact that we were guaranteeing corporate credits – mostly of the high-yield variety – throughout the financial panic and subsequent recession. In our other major derivatives commitment, we sold long-term puts on four leading stock indices in the U.S., U.K., Europe and Japan. These contracts were initiated between 2004 and 2008 and even under the worst of circumstances have only minor collateral requirements. In 2010 we unwound about 10% of our exposure at a profit of $222 million. The remaining contracts expire between 2018 and 2026. Only the index value at expiration date counts; our counterparties have no right to early termination. Berkshire received premiums of $4.2 billion when we wrote the contracts that remain outstanding. If all of these contracts had come due at yearend 2011, we would have had to pay $6.2 billion; the corresponding figure at yearend 2012 was $3.9 billion. With this large drop in immediate settlement liability, we reduced our GAAP liability at yearend 2012 to $7.5 billion from $8.

The profile of the remaining 2011 earnings – $4,387 million – illustrates the comeback of much of America from the devastation wrought by the 2008 financial panic. Though housing-related businesses remain in the emergency room, most other businesses have left the hospital with their health fully restored. * * * * * * * * * * * * Almost all of our managers delivered outstanding performances last year, among them those managers who run housing-related businesses and were therefore fighting hurricane-force headwinds. Here are a few examples: • Vic Mancinelli again set a record at CTB, our agricultural equipment operation. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash. Vic has made a number of bolt-on acquisitions over the years, including a meaningful one he signed up after yearend. • TTI, our electric components distributor, increased its sales to a record $2.1 billion, up 12.4% from 2010. Earnings also hit a record, up 127% from 2007, the year in which we purchased the business. In 2011, TTI performed far better than the large publicly-traded companies in its field. That’s no surprise: Paul Andrews and his associates have been besting them for years. Charlie and I are delighted that Paul negotiated a large bolt-on acquisition early in 2012. We hope more follow. • Iscar, our 80%-owned cutting-tools operation, continues to amaze us.

One additional point about these two new arrivals. Both Ted and Todd will be helpful to the next CEO of Berkshire in making acquisitions. They have excellent “business minds” that grasp the economic forces likely to determine the future of a wide variety of businesses. They are aided in their thinking by an understanding of what is predictable and what is unknowable. * * * * * * * * * * * * There is little new to report on our derivatives positions, which we have described in detail in past reports. (Annual reports since 1977 are available at www.berkshirehathaway.com.) One important industry change, however, must be noted: Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength. Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon.

At the 2010 Berkshire annual meeting, two years into the recovery from the 2008 crisis, I was asked whether the bailouts had been wise. I told the audience that the bailouts had been necessary, in the panic phase, because the alternative was a complete collapse of the credit system, and the cost of the collapse would have been far larger than the cost of the bailouts. The capital-allocation-discipline lesson I tried to convey was that the government, as the lender of last resort, had played a role that no private balance sheet could have played, and that the bailouts had, in aggregate, returned a profit to the taxpayer. The investor who recognised the necessity of the bailouts, and who refused to moralise about them, had a clearer view of the crisis than the investor who insisted that the bailouts were a moral hazard that should not have been provided. The mistakes-and-learning discussion at the 2010 meeting was, as always, the most useful part. I told the audience that the biggest mistake Berkshire had made during the crisis was not buying more when the prices were at their lows. The opportunity cost of that hesitation was, in dollar terms, very large. The lesson I tried to convey was that the disciplined investor must be willing to act during a crisis, even when the outlook is unclear, even when the prices may go lower before they go higher. The investor who waits for clarity misses the move. The investor who acts when the headlines are still terrifying, who buys wonderful businesses at panic prices, and who refuses to sell during the early volatility, has an enormous long-run advantage over the investor who waits for the all-clear signal that, in retrospect, never comes from the economists until the move has already happened. The market-psychology element I tried to add was that the credit cycle does not end in scarcity; it ends in abundance, when lenders, having forgotten the losses of the previous scarcity, begin lending freely again to borrowers who cannot repay. The investor who recognises this pattern, and who positions his portfolio for the next phase of the cycle rather than for the current phase, has an enormous advantage over the investor who assumes the current phase will continue forever. The 2010 meeting was, in some ways, a summing-up of the crisis. I told the audience that the lessons I had learned in two years of crisis were the same lessons I had learned in the previous four decades: buy wonderful businesses, hold them for a long time, refuse to be panicked out by short-term volatility, and never forget that the long run is the only horizon that matters for the investor with the right temperament and a strong balance sheet. The crisis had not changed the lessons; it had only confirmed them.

Every day Charlie and I think about how we can build on this base. Both of us are enthusiastic about BNSF’s future because railroads have major cost and environmental advantages over trucking, their main competitor. Last year BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That’s three times more fuel-efficient than trucking is, which means our railroad owns an important advantage in operating costs. Concurrently, our country gains because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits. Over time, the movement of goods in the United States will increase, and BNSF should get its full share of the gain. The railroad will need to invest massively to bring about this growth, but no one is better situated than Berkshire to supply the funds required. However slow the economy, or chaotic the markets, our checks will clear. Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.

Subsequently, as you know too well, we encountered both a financial panic and a severe recession. A number of the companies in the high-yield indices failed, which required us to pay losses of $2.5 billion. Today, however, our exposure is largely behind us because most of our higher-risk contracts have expired. Consequently, it appears almost certain that we will earn an underwriting profit as we originally anticipated. In addition, we have had the use of interest-free float that averaged about $2 billion over the life of the contracts. In short, we charged the right premium, and that protected us when business conditions turned terrible three years ago. Our other large derivatives position – whose contracts go by the name of “equity puts” – involves insurance we wrote for parties wishing to protect themselves against a possible decline in equity prices in the U.S., U.K., Europe and Japan. These contracts are tied to various equity indices, such as the S&P 500 in the U.S. and the FTSE 100 in the U.K. In the 2004-2008 period, we received $4.8 billion of premiums for 47 of these contracts, most of which ran for 15 years. On these contracts, only the price of the indices on the termination date counts: No payments can be required before then. As a first step in updating you about these contracts, I can report that late in 2010, at the instigation of our counterparty, we unwound eight contracts, all of them due between 2021 and 2028.

We keep our cash largely in U.S. Treasury bills and avoid other short-term securities yielding a few more basis points, a policy we adhered to long before the frailties of commercial paper and money market funds became apparent in September 2008. We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.” At Berkshire, we don’t rely on bank lines, and we don’t enter into contracts that could require postings of collateral except for amounts that are tiny in relation to our liquid assets. Furthermore, not a dime of cash has left Berkshire for dividends or share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month. Our net worth has thus increased from $48 million to $157 billion during those four decades and our intrinsic value has grown far more. No other American corporation has come close to building up its financial strength in this unrelenting way. By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

At the 2009 annual meeting, six months into the recovery from the March 2009 lows, I was asked whether the worst was over. I told the audience that I did not know whether the economy had bottomed, and that I did not need to know. What I knew was that the prices being offered for wonderful American businesses were still attractive, and that the long-run returns from buying wonderful businesses at attractive prices were very high. The market-psychology point I tried to convey was that the investor who waits for the all-clear signal from the economists will miss the move. By the time the economists agree that the recession is over, the market has already moved. The discipline required is to buy when the headlines are still terrifying and the outlook is still unclear, and to hold on through the volatility that always accompanies the early phase of a recovery. That discipline is far harder to apply than to describe. The mistakes-and-learning discussion at the 2009 meeting was, as always, my favourite part. I told the audience that the biggest mistake I had made during the crisis was selling too early. I had bought ConocoPhillips at high prices as oil was crashing, when I should have waited for oil to fall further. I had also bought some Irish bank bonds that turned out to be worth less than I paid, and I had paid too much for a stake in two Irish banks. The lesson I tried to convey was that even the disciplined investor makes mistakes during a crisis, because the speed of the price collapse tempts even the patient buyer to act before the prices have fully adjusted. The correction is to size positions conservatively, to average in over time, and to be honest with oneself about which mistakes were process errors and which were simply bad luck. The contrarianism lesson of 2009 is the one I have tried hardest to teach. The investor who bought during the March 2009 lows, when the headlines were predicting the end of capitalism, made returns of several hundred percent over the next decade. The investor who sold during the March 2009 lows, who panicked and went to cash, has still not recovered the purchasing power he gave up. The difference between the two outcomes is not intelligence; it is temperament. The investor with the temperament to buy when the world is ending, and to hold on through the early volatility, will outperform the investor with the higher IQ who panics at the bottom. That is the single most important lesson I have learned in six decades of investing, and it is the lesson I have repeated most often to the students who visit Omaha each spring. Temperament, more than intelligence, determines the long-run return.

Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes. • We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses. When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help. Of that, $9 billion went to bolster capital at three highly-regarded and previously-secure American businesses that needed – without delay – our tangible vote of confidence. The remaining $6.5 billion satisfied our commitment to help fund the purchase of Wrigley, a deal that was completed without pause while, elsewhere, panic reigned.

In October 2008, with the world's financial system apparently collapsing, I wrote an op-ed for the New York Times titled Buy American. I Am. The headline was not a slogan; it was a description of what I was actually doing with my personal account. I was buying American stocks. The rule that guided me was simple, and I had learned it from Graham decades earlier: be fearful when others are greedy, and be greedy when others are fearful. In the autumn of 2008, fear was at a level I had rarely seen. The S&P 500 had fallen by more than forty percent from its peak, and most observers believed the decline was only beginning. My view was the opposite: the panic had made wonderful businesses available at prices that, in normal times, would have been unthinkable. The pessimism was so thick that even strong, well-capitalised companies were being dumped at distress prices. What I wrote in the op-ed, and what I still believe, is that the long-term outlook for American business was not as bad as the prices implied. The simple rule is that stocks, over time, will outperform cash, because businesses earn a return on capital and cash earns nothing after inflation. During a panic, the market prices stocks as if cash is the only safe asset, and that pricing is almost always wrong. I did not claim to know where the bottom would be. I have never known where the bottom will be, and I never will. What I claimed was that buying a slice of America's future at a marked-down price was the rational bet, made repeatedly over many months, and that the long-run outcome would reward the investor who was willing to look foolish in the short run while he was buying what others were panic-selling. The market-psychology lesson is the most important one. Most investors, when they see the market fall, conclude that the world is ending and they sell at the worst possible moment. The few who hold on are, paradoxically, often the ones who never look at their statements during the panic. The investor who buys when the headlines are terrifying, and who refuses to sell when his neighbours are panicking, has an enormous long-run advantage over the investor who waits for clarity. Clarity, I wrote in 2008, is what kills long-run returns, because by the time the outlook is clear, the prices have already moved. The patience lesson is the simplest one in investing and the hardest to apply: do nothing when the market is calm, do nothing when the market is euphoric, but buy aggressively when the market is in a panic. That is what I was doing in October 2008.

At the Berkshire annual meeting in May 2008, the financial crisis was already underway but had not yet reached its climax. I told the audience that the credit cycle had turned, that the easy money that had fuelled the housing bubble was gone, and that the unwind would take years rather than months. The mistakes that had been made during the boom were the standard ones: lenders had underwritten loans on the assumption that house prices would keep rising, ratings agencies had stamped triple-A on bonds whose underlying collateral was suspect, and investors had bought those bonds on the assumption that the ratings agencies knew what they were doing. The cycle had taught me, once again, that credit is a pendulum. It swings from abundant to scarce with a violence that surprises everyone who had grown comfortable during the easy phase. The investor who survives the swing is the one who has positioned his balance sheet for the scarce phase before it arrives. The contrarianism angle was the one that mattered most. I told the meeting that the worst time to sell a stock was during the panic phase of a credit cycle, and the best time to buy was during the same panic. Most investors, however, do the opposite: they buy during the easy phase because prices are rising, and they sell during the scarce phase because prices are falling. The investor who can invert that pattern, who can buy when the headlines are terrifying and refuse to sell when his neighbours are panicking, has an enormous long-run advantage. I had been buying throughout the crisis, both for Berkshire and for my personal account. The reason was simple: the prices being offered for wonderful businesses were absurdly low, and the long-run returns from buying wonderful businesses at low prices are very high. The discipline required was patience, and the resource required was a balance sheet strong enough to absorb short-term paper losses without being forced to sell. The credit-cycles lesson I have repeated most often is that the pendulum always swings back. The credit cycle does not end in scarcity; it ends in abundance, when lenders, having forgotten the losses of the previous scarcity, begin lending freely again to borrowers who cannot repay. The investor who recognises this pattern, and who positions his portfolio for the next phase of the cycle rather than for the current phase, has an enormous advantage over the investor who assumes the current phase will continue forever. The 2008 crisis was, in this sense, no different from the 1990 savings-and-loan crisis, the 1998 Long-Term Capital Management crisis, or the 2000 dot-com unwind. The names of the assets change; the underlying psychology does not. The investor who memorises that single observation, and who acts on it with patience and a strong balance sheet, will outperform the elaborate risk-management models of the largest banks in nearly every cycle.

Things also went well on the capital-allocation front last year. Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy. In our insurance portfolios, we made three large investments on terms that would be unavailable in normal markets. These should add about $1 1⁄2 billion pre-tax to Berkshire’s annual earnings and offer possibilities for capital gains as well. We also closed on our Marmon acquisition (we own 64% of the company now and will purchase its remaining stock over the next six years). Additionally, certain of our subsidiaries made “tuck-in” acquisitions that will strengthen their competitive positions and earnings. That’s the good news. But there’s another less pleasant reality: During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action. Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions.

In 2007 I made a ten-year bet with the New York hedge fund Protege Partners, staking one million dollars on the proposition that a low-cost S&P 500 index fund would outperform a basket of hedge funds-of-funds over the next decade. The bet was a public test of a private belief: that the fees charged by active managers, in aggregate, would consume more than any edge they could produce. The bet, registered at Long Bets, ran from January 2008 through December 2017. The index fund returned one hundred and twenty-five percent over the ten years, while the basket of hedge funds-of-funds returned thirty-six percent. The difference was not skill; it was fees. The hedge funds charged two-and-twenty on their assets, and the funds-of-funds charged an additional layer on top. The investor in the index fund paid nearly nothing, and he kept nearly all of the returns the market produced. The capital-allocation-discipline lesson was that the investor who is honest about his own limitations, and who refuses to pay active-management fees for an edge he cannot identify, has a long-run advantage over the investor who pays the fees on the assumption that the managers can produce an edge. The market-psychology element was that most investors, when they see hedge-fund returns, attribute the returns to skill rather than to the market, and they pay the fees for the skill that, in aggregate, does not exist. The hedge-fund industry, in aggregate, cannot outperform the market, because the hedge-fund industry is a part of the market, and the fees it charges are deducted from the market's return. The investor who recognises this simple arithmetic, and who refuses to pay the fees for an edge that does not exist in aggregate, has an enormous long-run advantage over the investor who pays the fees on faith. The index-investing lesson of the bet was the one I had been teaching for decades. The investor who buys a low-cost index fund, who holds it for a long time, and who refuses to be panicked out by short-term volatility, will, in the long run, outperform the vast majority of active managers. The reason is arithmetic, not skill. The fees charged by active managers, in aggregate, must come out of the market's return. The investor who pays the lowest fees, and who holds the broadest basket, captures the market's return minus the smallest possible fee. The investor who pays active-management fees, in aggregate, captures the market's return minus the fees. The bet with Protege Partners was, in effect, a public test of this arithmetic, and the arithmetic produced exactly the outcome I had predicted. The lesson I tried to convey was that the investor who understands the arithmetic has the long run on his side.

At the 2005 Berkshire annual meeting, I was asked about the housing market and the lending standards being applied to mortgage loans. I told the audience that the prices being paid for houses, in some markets, had become detached from the rents that comparable houses could generate, and that the gap was being financed by lending standards that, in normal times, would not have been acceptable. The market-psychology point I tried to convey was that the crowd, in its optimistic phase, convinces itself that the rules of valuation have been suspended. They have not. What has been suspended is only the willingness of lenders to enforce the rules. The capital-allocation-discipline lesson was that the investor who recognised the suspension, and who refused to participate in the loans or the securities backed by those loans, had a long-run advantage over the investor who chased the prices on the assumption that the rules had been permanently suspended. The mistakes-and-learning discussion at the 2005 meeting was, as always, my favourite part. I told the audience that the biggest mistake of the previous decade was not a bad investment; it was a missed investment. There were several wonderful businesses that I had studied carefully, understood well, and failed to buy when they were cheap. The opportunity cost of those misses was, in dollar terms, very large. The lesson I tried to convey was that the investor who is honest about his mistakes of omission, not just his mistakes of commission, learns far more than the investor who only celebrates his winners. The market rewards the investor who admits he was wrong, writes down the lesson, and applies it the next time. The market punishes the investor who refuses to acknowledge his mistakes, because that investor never learns, and he keeps repeating them at progressively larger scale. The capital-allocation-discipline point I tried to add was that the investor who buys wonderful businesses at reasonable prices, and who refuses to chase the prices that easy money had temporarily supported, has the long run on his side. The investor who chases the prices, on the assumption that easy money will last forever, learns, painfully, that the prices of assets are bounded by the cash those assets will eventually distribute to their owners. The 2005 meeting was, in retrospect, a warning about the housing bubble that would, two years later, begin to unwind. The investor who recognised the warning, and who positioned his portfolio for the unwind, survived the crisis. The investor who ignored the warning, and who chased the prices, learned the lesson the hard way. The lesson I tried to convey was that the disciplined investor must be willing to recognise a bubble when he sees one, and to refuse to participate, even at the cost of looking unfashionable during the boom.

At the 2004 Berkshire annual meeting, I was asked about the housing market and the credit standards being applied to mortgage loans. I told the audience that the prices being paid for houses, in some markets, had become detached from the rents that comparable houses could generate, and that the gap was being financed by lending standards that, in normal times, would not have been acceptable. The market-psychology point I tried to convey was that the crowd, in its optimistic phase, convinces itself that the rules of valuation have been suspended. They have not. What has been suspended is only the willingness of lenders to enforce the rules. The capital-allocation-discipline lesson was that the investor who recognised the suspension, and who refused to participate in the loans or the securities backed by those loans, had a long-run advantage over the investor who chased the prices on the assumption that the rules had been permanently suspended. The mistakes-and-learning discussion at the 2004 meeting was, as always, my favourite part. I told the audience that the biggest mistake of the previous decade was not a bad investment; it was a missed investment. There were several wonderful businesses that I had studied carefully, understood well, and failed to buy when they were cheap. The opportunity cost of those misses was, in dollar terms, very large. The lesson I tried to convey was that the investor who is honest about his mistakes of omission, not just his mistakes of commission, learns far more than the investor who only celebrates his winners. The market rewards the investor who admits he was wrong, writes down the lesson, and applies it the next time. The market punishes the investor who refuses to acknowledge his mistakes, because that investor never learns, and he keeps repeating them at progressively larger scale, until the cost of the mistake becomes existential. The capital-allocation-discipline point I tried to add was that the investor who buys wonderful businesses at reasonable prices, and who refuses to chase the prices that easy money had temporarily supported, has the long run on his side. The investor who chases the prices, on the assumption that easy money will last forever, learns, painfully, that the prices of assets are bounded by the cash those assets will eventually distribute to their owners. The 2004 meeting was, in retrospect, a warning about the housing bubble that would, three years later, begin to unwind. The investor who recognised the warning, and who positioned his portfolio for the unwind, survived the crisis. The investor who ignored the warning, and who chased the prices, learned the lesson the hard way. The lesson I tried to convey was that the disciplined investor must be willing to recognise a bubble when he sees one, and to refuse to participate, even at the cost of looking unfashionable during the boom.

The 2003 letter returned to a theme I had first written about in the late 1970s: inflation is a tax on the investor, and no amount of trading skill makes it disappear. When inflation runs at seven percent, a business earning twelve percent on equity is, after inflation, earning about five percent in real terms. The math is brutal and it is unavoidable. What the 2003 letter added to the earlier argument was a specific warning about currency. We had placed a multi-billion-dollar bet against the dollar because we believed the United States was running trade deficits that could not be sustained without a gradual decline in the currency. The bet was an inflation hedge, not a speculation. We were trying to own purchasing power that would not be eroded by the policy choices we saw coming, choices we believed would push the dollar lower against other major currencies over the next several years. That decision illustrates capital-allocation discipline in its purest form. We did not claim to know what the dollar would do next week, and we explicitly said so. What we claimed to know was that the structural forces pushing the dollar lower were large, persistent, and not yet reflected in the price of currency futures. So we allocated a portion of Berkshire's float to a position whose expected return was positive even though its short-term volatility was high. This is the essence of risk management: you size your bet to the size of your edge, you hold cash to absorb the volatility, and you refuse to be panicked out by short-term mark-to-market losses. The position moved against us for a long time before it moved in our favour, and we held it because our view of the structural forces had not changed over the period. The market-psychology dimension of the dollar trade is the one that almost nobody gets right. Most investors, when they see a paper loss, conclude that their original analysis was wrong and they exit at the worst possible moment. They sell when the crowd is most fearful and buy when the crowd is most greedy, which is the precise opposite of what produces long-run returns. The dollar trade worked for Berkshire because we had thought about the structural forces before we bought, we had pre-committed to the size, and we had the balance-sheet strength to wait. The lesson I tried to convey in the 2003 letter was that inflation is not a force you trade around; it is a force you allocate against, with patience, with a strong balance sheet, and with the willingness to look wrong for a long time before you are eventually right.

In the 2002 shareholder letter I discussed derivatives at length, calling them financial weapons of mass destruction. The phrase was deliberate. We had watched Long-Term Capital Management almost bring the system down in 1998, and we had stumbled into a multi-billion-dollar basket of credit-default contracts whose mark-to-market swings were already producing large paper losses. The lesson I drew was not that derivatives are inherently evil, but that any contract whose value depends on the perceived creditworthiness of distant counterparties contains an embedded view on crowd psychology that the buyer almost never models honestly. People price these instruments as if normal times will continue forever, and then, when the cycle turns, the supposed hedge becomes the source of the loss. The discipline we adopted was to refuse contracts we could not underwrite ourselves, even at the cost of looking unfashionable in a busy, optimistic market. That same letter describes how our Gen Re Securities derivatives unit had been quietly building exposures we did not fully understand. The decision was to spend whatever it took, in money and managerial time, to unwind the book over several years rather than sell it quickly at a fire-sale price. Capital-allocation discipline here meant the willingness to absorb a known, ugly loss today in exchange for not owning a much uglier and unpredictable loss tomorrow. We treated the derivatives exit as an insurance underwriting problem: estimate the expected loss, add a margin for error, charge it off, and walk away. The cycle had taught us that complexity in finance is itself a form of leverage, because it hides the true exposure during the calm part of the cycle and reveals it only when liquidity vanishes and counterparties start failing in the next downturn. The market-psychology lesson is the one I have repeated most often since. During the late-1990s bubble, otherwise intelligent people convinced themselves that the rules of business valuation had been repealed by the internet. They had not. What had been repealed was only the willingness of lenders and counterparties to enforce the old rules. When the cycle turned, those rules came back with a vengeance, and the contracts written under the assumption that they would never return produced losses proportional to the optimism that had preceded them. The investor who remembers that crowd psychology is cyclical, not linear, has an enormous advantage over the investor who believes that whatever is happening today will continue happening forever. That single insight, applied patiently and with a strong balance sheet, explains most of Berkshire's long-run advantage over the traders who feed on noise and daily headlines.

At Sun Valley in July 1999 I gave a talk about the stock market that Carol Loomis later published in Fortune under the headline Warren Buffett on the Stock Market. The talk was unusual for me because I almost never make public comments about the level of the market. What I said, in essence, was that the previous seventeen years had produced returns far above what the underlying businesses had earned, and that those excess returns could not continue forever. The math was simple. If corporate profits grow at roughly the rate of GDP, and interest rates stay roughly constant, then stock returns over long periods must converge on the rate of corporate-profit growth plus the dividend yield. The seventeen-year run of double-digit returns had been pulled forward from the future, and the future would have to pay the bill. The talk was not a forecast of a crash; it was a forecast of reversion to the mean. The valuation framework I sketched was the simplest one I know. The value of all publicly traded stocks, in aggregate, is bounded by the present value of the cash those businesses will eventually distribute to their owners. That present value is highly sensitive to interest rates. When rates fall, the present value rises, and stocks go up. When rates rise, the present value falls, and stocks go down. The 1982 to 1999 bull market had been driven by two forces: a tripling of price-to-earnings ratios, and a halving of interest rates. Neither of those forces could be repeated. The market, in 1999, was pricing in a future in which interest rates would keep falling and earnings would keep growing at unprecedented rates. I argued that the realistic expectation was for nominal stock returns over the next seventeen years to be roughly in the range of three to five percent annually after inflation. The market-psychology element was the most important part of the talk. Crowds, in their optimistic phases, convince themselves that the rules of valuation have been suspended. They have not. What has been suspended is only the willingness of investors to enforce the rules. When the enthusiasm wears off, the same rules return, and the prices adjust downward with a speed that surprises everyone who had convinced themselves that the new era was permanent. The investor who understands that the rules of valuation are constant, and that only the willingness to enforce them is cyclical, has an enormous advantage over the investor who believes that whatever is happening today will continue forever. The inflation angle is the one I tried to add to Graham's framework. Inflation is a tax on capital that no amount of clever trading can avoid; the only defence is to own businesses whose pricing power lets them push the inflation tax onto their customers.

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing.

I emphasize this lugubrious point because I would not want you to panic and sell your Berkshire stock upon hearing that some large catastrophe had cost us a significant amount. If you would tend to react that way, you should not own Berkshire shares now, just as you should entirely avoid owning stocks if a crashing market would lead you to panic and sell. Selling fine businesses on "scary" news is usually a bad decision. (Robert Woodruff, the business genius who built Coca-Cola over many decades and who owned a huge position in the company, was once asked when it might be a good time to sell Coke stock. Woodruff had a simple answer: "I don't know. I've never sold any.")

In the super-cat business, we have three major competitive advantages. First, the parties buying reinsurance from us know that we both can and will pay under the most adverse of circumstances. Were a truly cataclysmic disaster to occur, it is not impossible that a financial panic would quickly follow. If that happened, there could well be respected reinsurers that would have difficulty paying at just the moment that their clients faced extraordinary needs. Indeed, one reason we never "lay off" part of the risks we insure is that we have reservations about our ability to collect from others when disaster strikes. When it's Berkshire promising, insureds know with certainty that they can collect promptly.

In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity.

Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices. Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product. Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." * * * * * * * * * * * * Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.) Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly.

Because we are delighted by our experience with Jim, HBI and the NYSE, I said as much in ads that have been run in a series placed by the NYSE. Normally I shun testimonials, but I was pleased in this instance to publicly compliment the Exchange. Last summer we sold the corporate jet that we purchased for $850,000 three years ago and bought another used jet for $6.7 million. Those of you who recall the mathematics of the multiplying bacteria on page 5 will understandably panic: If our net worth continues to increase at current rates, and the cost of replacing planes also continues to rise at the now-established rate of 100% compounded annually, it will not be long before Berkshire's entire net worth is consumed by its jet.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic- depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.

However, our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price. To that, I will add one qualifier: These stocks are held by our insurance companies and we would, if absolutely necessary, sell portions of our holdings to pay extraordinary insurance losses. We intend, however, to manage our affairs so that sales are never required.

The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices - dramatically below those commanded in negotiated transactions that transfer control. For example, we purchased our Washington Post stock in 1973 at $5.63 per share, and per-share operating earnings in 1987 after taxes were $10.30. Similarly, Our GEICO stock was purchased in 1976, 1979 and 1980 at an average of $6.67 per share, and after-tax operating earnings per share last year were $9.01. In cases such as these, Mr. Market has proven to be a mighty good friend.

o Let's look first at common stocks. During 1987 the stock market was an area of much excitement but little net movement: The Dow advanced 2.3% for the year. You are aware, of course, of the roller coaster ride that produced this minor change. Mr. Market was on a manic rampage until October and then experienced a sudden, massive seizure. We have "professional" investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.

At Berkshire, we have found little to do in stocks during the past few years. During the break in October, a few stocks fell to prices that interested us, but we were unable to make meaningful purchases before they rebounded. At yearend 1987 we had no major common stock investments (that is, over $50 million) other than those we consider permanent or arbitrage holdings. However, Mr. Market will offer us opportunities - you can be sure of that - and, when he does, we will be willing and able to participate.

What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

As this is written, little fear is visible in Wall Street. Instead, euphoria prevails - and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.

In May 1984, at Columbia Business School, I gave a speech called The Superinvestors of Graham-and-Doddsville in honour of the fiftieth anniversary of Graham and Dodd's Security Analysis. The speech was a defence of value investing against the academic claim that the market was efficient and that no investor could, in aggregate, outperform. The argument I made was that a group of investors, all of whom had been trained in the same value-investing tradition, and none of whom had access to non-public information, had produced long-run records that, taken together, were extremely unlikely to have occurred by chance. The group included Walter Schloss, Tom Knapp, Bill Ruane, Charlie Munger, Stan Perlmeter, and Rick Guerin. Each had compounded capital at rates well above the market over periods of one to two decades, and each had done so with portfolios that bore very little resemblance to the market index. The market-psychology point was that the value tradition gave each of them a temperamental advantage that the efficient-market hypothesis could not model. The contrarianism angle was the most important part. Each of the superinvestors had, at one time or another, held substantial cash because the prices being offered for the businesses they understood did not meet their standards. None of them had felt pressure to be fully invested at all times, and none of them had felt pressure to mimic the holdings of the index. The market-psychology point I tried to convey was that the discipline of refusing to buy when the prices were not attractive, and of holding cash while waiting for attractive prices, was the single most important differentiator between the value tradition and the index tradition. The value investor, by waiting for his pitch, had a long-run advantage over the index investor, who was forced to be fully invested at all times, regardless of the prices being offered. The moat that protected the value investor's returns was a temperamental moat, not a business moat. The moats lesson I tried to add to Graham's framework was that the businesses the superinvestors owned were, in many cases, businesses with durable competitive advantages. Charlie Munger had been the most articulate advocate of the shift from cigar-butt investing toward wonderful-businesses-with-moats investing. The shift had produced, in Charlie's record, returns even higher than those of the other superinvestors, and the reason was that the wonderful businesses had compounded their earnings at higher rates than the cigar butts, and the compounding had, over decades, dwarfed the entry-price advantage. The market-psychology lesson was that the investor who recognised both the temperamental advantage and the moats advantage, who combined the patience to wait for his pitch with the judgment to recognise a wonderful business, had the best of both worlds. That single insight, applied over a working life, had produced the long-run records of the superinvestors, and it was the lesson I most wanted to convey to the students who had gathered at Columbia that spring.