The results of Warren Buffett are both extraordinary and seemingly withing the realm of possibility at the same time. He has managed to average a 22% annual return over his investing and savings lifetime. Which is currently from when he was about 10 to 90. That is 80 years of compound growth.
It is not the annual return in itself that is remarkable, but the consistancy over time.
The average person saves for retirement from when they are 30 to when they are 60. This is a mere 30 years of growth. To illustrate why this makes a difference, if you start with $5,000 and compound it at 22% for 80 years, you end up with 40 billion dollars. If you compound the same $5,000 over 30 years, the result is $1.9 million dollars.
Now, 22% is an exceptional rate of return. It is not predictably achievable by simply putting money in a single fund over the years and expecting those results over time. It is achievable, or at least within the realm of expected returns, with a more active approach. Especially when looking at closely held assets or companies.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest” Warren Buffet
The biggest factor in Warren Buffet's wealth is time. Over the years he has been outperformed by many investors for several year stretches. However, Warren's remarkable results come from steady growth over a large magnitude of years.
This is not to say that every year is consistent growth like an annuity payout. There are good years and bad years. Overall, there are many more good years than bad years. He also has the sense not to lock in losses and sell at the bottom of a market.
Compounding takes time. It is slow, and boring. One reason why Warren Buffett says people do not really replicate what he is doing is that “no one wants to get rich slow.”
Kind of like Warren Buffett's strategy, real estate investing is a great get rich slow vehicle. In real estate, gains are accrued over time, and factors such as appreciation, principal paydown, and rent growth take years. Yes, you can benefit from forced appreciation, but the big wealth from real estate takes time.
“Read 500 pages every day. That's how knowledge works. It builds up like compound interest” Warren Buffett
Warren buffett has a rule: Go to bed smarter each day. That is the simple principle he follows that has allowed him to become one of the wealthiest men in the world. Not just financially, but also in knowledge.
Warren Buffett leverages an intense knowledge of business and the market to increase his returns. He says that knowledge compounds just like money does. This is important to note, because as capital increases, so does the complexity of the underlying assets. Starting out, with $20,000 you could go out and buy some equipment that will earn a nice annual return. At 200 million, you are likely investing in a much more complicated system.
“The best investment you can make, is an investment in yourself… The more you learn. The more you'll earn.” Warren Buffett
How does Warren continue to learn? He reads 500 pages a day. He reads 5 newspapers daily, business annual reports, and books. There is a lot of information that can be learned from these sources. Every day he is learning new things about various industries and enhancing his expertise.
Circle of Competence
“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter” Warren Buffett
Not only is Warren learning every day, but he is focusing his operations on what he knows well. This is in stark contrast to many businesses who operate with an undisciplined pursuit of more. By operating outside of your circle of competence, there is a much higher degree of risk.
“Never invest in a business you can't understand” Warren Buffett
Warren even seems to apply the circle of competence to his eating habits. He does not stray from the things he knows he likes. Eating a diet that consists of Hamburgers, Coke, and ice cream.
This shows that he is applying the principle of the circle of competence to other areas of his life than investing. Which probably makes it easier to stick to the principle when it comes to investing.
That does not mean Warren Buffett doesn't dabble outside of his circle of competence. He will approach things outside, or near the perimeter of his circle of competence with insignificant investments as a way of increasing his knowledge. As he has expanded his circle of competence, he will later deploy larger investments.
Don't Lose Money
“Rule Number 1: Don't lose money. Rule Number 2: Never forget rule Number 1.” Warren Buffett
Warren Buffett hates losing principal. It really destroys compound growth. If you lose 50% of your capital, it will take years of solid growth just to get back to where you were before.
This ties to working inside of your circle of competence. Working outside of your circle of competence is putting your principal at substantial risk.
Even if you are not investing in stocks, this has applications to business and real estate. In real estate, one way to minimize the risk of losing principal is to secure long term debt, If you own a property on short term debt, and the market moves against you, you may be forced to sell at a substantial loss.
Sit on Your Ass
“Our favorite holding period is forever” Warren Buffett
Warren Buffett breaks from his teacher Ben Graham in one notable way, which allows him to invest for the long haul. This way is by investing in quality companies.
Ben Graham instructed his students to find “cigar butts” on the sidewalk.
These “cigar butt” companies have intrinsic values lower than the share price. Upon finding these companies, his students would take one last puff before discarding them. The theory is, a portfolio of these “cigar butts” will as a whole, trend towards their intrinsic value.
To contrast the “one puff cigar butts,” Warren Buffett places value on goodwill and other intangibles. These intangibles are what allows him to focus on a longer holding period.
“If you buy a business just because it's undervalued then you have to worry about selling it when it reaches its intrinsic value. That's hard. But if you can buy a few great companies then you can sit on your ass … that's a good thing.” Charlie Munger
This is sort of the opposite of r/WallStreetBets' philosophy that recently recieved the attention of the world. The idea of picking a company and investing in it for the long haul.
Invest In Management
“Look at what they have accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry” Warren Buffett
Warren Buffett places a large factor on the quality of a management team. When he buys a company, he prefers to buy one with a “.400 batting average” and doesn't try to tell them “how to swing the bat.”
He looks for management that takes shareholders into consideration above the institutional imperative. Which roughly means he is looking for management that prefers the bottom line to making themselves look good or creating a cushy environment for themselves.
Even though quality management is super important, Warren likes to invest in companies that have such strong fundamentals they can overpower poor management.
He is quoted as saying “a ham sandwich could run Coca-Cola” to his friend Bill Gates.
He later said this is a good thing because it turns out that Coca-Cola did in fact have a few ham sandwiches at the helm over the years.
According to Berkshire Hathaway's 2020 shareholder meeting, Coke was the 3rd largest holding in their portfolio.
Importance of Reputation
“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.” Warren Buffett
Warren Buffett protects and builds his reputation fiercely. It possibly has a higher priority than Rule No. 1. Don't Lose Money.
He knows that it only takes one mistake to ruin a reputation. Not only does he protect his own reputation, but also the businesses he owns.
This reputation of not being super greedy, buying companies only to parcel them out and gut the management gets him more deals.
When he is making moves to merge with a company, management can look at his track record of keeping the company operating and take comfort in that. In a tightly held company this has extreme value as management often serves on the board or is tightly wound to the board.
Even if you are not buying up whole companies, can you see how Warren Buffett's approach to reputation could benefit you?
Wrapping it Up
There is a lot that can be learned from Warren Buffett. Even if you are not investing in stocks, or buying up whole companies, his investment style and money management can be applied to individuals.
There is tons to learn from how he learns. The principle of going to bed smarter than when you woke up can be applied to anyone's life. Over time that compounding of knowledge shows stunning results.
Warren lives in an area of tension between two conflicting ideas and brings them together. For instance he values management, but also values companies that are strong enough to be able to survive with poor management.
In investing, like many areas in life, consistency and discipline pays off very well. It is Warren Buffett's consistency and discipline that has allowed him to string together 80 remarkable years of investing and capital growth.