Warren Buffett's Singular Focus on Compounding

Warren Buffett has understood how compounding works from a young age

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Jun 08, 2021
Summary
  • Warren Buffett has historically compounded his capital at a high rate of return
  • This has been a key reason for his impressive performance over the past seven decades
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A lot of time and attention is spent analyzing Warren Buffett (Trades, Portfolio)'s investments. While we can learn a lot from the Oracle of Omaha's investment activity over the past seven decades, it's also important to acknowledge that some of the investment opportunities he could take advantage of no longer exist.

It's also important to recognize that Buffett is just one man. As such, a level of survivorship bias hangs over his career. It's simply impossible to say how many thousands of other investors have failed at trying to achieve the record he has. That being said, none can deny that he has a lot of experience regarding business and investing.

Buffett and the joys of compounding

Many investors spend too much time concentrating on Buffett's investments and not enough time on the process of wealth creation. Indeed, the Oracle of Omaha has made some notable investments in the past. Still, his ability to compound wealth year after year by avoiding significant losses, minimizing taxes and maximizing reinvestment potential are also reasons behind his success.

From a young age, the investor understood that being able to compound returns year after year is what matters. This has dictated his investment strategy ever since. Rather than concentrating on quick wins or speculating on rising or falling prices, Buffett has always focused on compounding his capital at the best possible rate.

The Oracle's thoughts on the topic of compounding used to appear regularly in his partnership letters to investors in the mid-1960s. For example, in his 1963 letter, Buffett presented the following example:

"I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000...Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point."

This clearly illustrated the benefits of compounding even at a low rate over an extended period. The investor presented another example in his 1964 letter:

"Francis I of France paid 4,000 écus in 1540 for Leonardo da Vinci's Mona Lisa...If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%...as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound."

What Buffett was trying to get across here is that even at a relatively modest rate of growth, an asset can produce great returns over the long run if it compounds consistently.

However, this is only achievable if the compounding rate is positive and there are no significant losses along the way. By losses, I mean permanent capital impairments.

It is 57 years since Buffett first wrote the above. His compounding rate during this time has far exceeded the 4% or 6% presented in the above examples. In today's low return environment, investors may never be able to achieve the sort of returns the Oracle printed in his first few decades managing money. However, that does not make the points outlined above any less relevant. As Buffett wrote in 1963, "Such fanciful geometric progressions illustrate the value of either living a long time or compounding your money at a decent rate."

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure