Warren Buffett is the world's most famous investor.
According to the Forbes billionaire list, he is the third richest person in the world with an estimated net worth of $70.5 billion at the time of this writing.
Most of his wealth and investments are concentrated in his massive conglomerate, a corporation called Berkshire Hathaway (BRK.B) where Buffett is the CEO and biggest shareholder.
Importantly, Warren Buffett was not born rich and he didn't found a tech company like most of the world's top billionaires. Instead, he made his money by investing.
But what did he do specifically that caused him to become so enormously wealthy?
It can be broken down into two main factors:
- Several periods where he earned very large amounts of money
- Compound interest
Let's start by exploring how he made compound interest work in his favour.
Compound interest — the 8th wonder of the world?
It is often said that Albert Einstein called compound interest the 8th wonder of the world.
Whether Einstein actually said that is not certain, but it is true that compound interest is an incredibly powerful phenomenon.
Compound interest is when you add interest on top of the originally invested sum, which causes the interest to start collecting its own interest (interest on interest).
With compound interest, money grows on its own and multiplies over time. The longer it is allowed to grow, the bigger it gets, like a snowball rolling down a snowy hill.
Let's see what happens to a million dollars invested for several decades at a 20% average annual return. This return is similar to Warren Buffett's long-time track record.
After the first year, the investment returns are $200,000 (20% of $1 million). But the $200,000 is not withdrawn, and is instead invested for another year of 20% returns.
The second year's returns are also 20%, but this time the profit is $240,000 (20% of $1.2 million).
So each year the profits are re-invested, the money "compounds" — the profits start making their own profits — and then the profits' profits start making their own profits.
This is what happens to a million dollars invested at 20% compound interest:
- 1 year: $1,200,000 (+$200,000 per year)
- 2 years: $1,440,000 (+$240,000)
- 3 years: $1,728,000 (+$288,000)
- 4 years: $2,073,600 (+$345,600)
- 5 years: $2,488,320 (+$414,720)
After 5 years, the annual profit from the interest has more than doubled from $200,000 to over $400,000, simply because the amount invested at 20% is getting bigger each year.
But let's see what happens after decades of investing a million dollars at 20% interest:
- 10 years: $6,191,736
- 20 years: $38,337,600
- 30 years: $237,376,314
- 40 years: $1,469,771,568
- 50 years: $9,100,438,150
- 60 years: $56,347,514,353
So after 60 years at 20% interest, $1 million dollars has turned into $56 billion, an increase of 56 thousandfold or 5.6 million percent.
For the first year at 20% interest, the profit was $200,000. For the 60th year at the same interest rate, the profit was over $9 billion (that's 9 thousand millions in a single year!).
Warren Buffett had become a millionaire by the year 1962 and he has been compounding that first million for 58 years.
As you can see, a lot of Buffett's wealth can be explained by this simple mathematical concept — compound interest over a very long period of time.
Buffett was also never a big spender. Instead of spending, he invested and compounded his money. This is critically important for compound interest to work.
All this being said, getting 20% returns over a long period of time is not easy. The difficulty of achieving it is the reason why there is only one Warren Buffett and why he is called the "Oracle of Omaha."
A lot of Buffett's long-term track record can be explained by a few periods where he made very large amounts of money over several years. These time periods really helped drive up his average long-term return.
Early days of working and saving
Warren Buffett has been obsessed with money since he was a young child.
He made money in several ways when he was a kid, including by working regular jobs. He delivered newspapers for many years and also worked in his grandfather's grocery store.
Buffett even started some small businesses as a kid. One example is when he bought a used pinball machine for $25 and set it up in a barbershop and split the profits with the owner.
A week later, he had made enough money to buy a second machine. After a while, he had many pinball machines all over Washington, D.C. where he lived at the time.
He ended up selling the pinball machine business later for $1,000, which was a decent amount of money back then. That was a 4,000% (40X) investment return, not including the money he had already made from the business.
You can read more about Warren Buffett's early business ventures in his biography, Snowball, by Alice Schroeder.
The investment partnership is what made Buffett truly rich
Warren Buffett bought his first stock when he was 11 years old and he made decent profits from many of his early stock investments.
However, he didn't become a full-time investor until 1956 when he was 25 years old.
At this time, he started an investment partnership that ended up becoming the single biggest contributor to his enormous wealth.
His investment partnership started with just a few family members and close friends, but he ended up running several partnerships with many more investors.
In exchange for managing people's money, Buffett got a cut of the profits. This is similar to how hedge funds work today, where the manager charges a commission and gets a percentage of the profits.
The money invested in Buffett's partnerships grew so much that his cuts of the profits ended up making him very rich.
His net worth was over $100,000 when he started the partnerships. But when he closed them down 13 years later in 1969, his net worth had increased to $25 million.
At 38 years old, he was worth $25 million. That is equal to about $181 million in today's dollars when adjusted for inflation.
His early gains from the partnership explain a lot about his massive wealth today. Compounding $25 million for 50 years will obviously lead to enormous amounts of money.
Keep in mind that many of the people who invested in Buffett's partnership also became very rich. It was immensely profitable for all parties involved.
Buffett invests through Berkshire Hathaway
Buffet started buying stock in a company called Berkshire Hathaway in 1962. At the time, Berkshire was a struggling textile company.
Over a period of several years, Buffett's partnerships had bought the majority of the shares in Berkshire, eventually making him the controlling owner.
After dissolving his investment partnerships in 1969, Warren managed most of his investments through Berkshire Hathaway. He owned Berkshire, while Berkshire owned the investments.
The textile business never recovered and eventually closed down. Because of this, Buffett has often joked that buying Berkshire was his worst investment.
However, Berkshire became a huge success under Buffett's management. He transformed it into a conglomerate of many different types of businesses.
Warren Buffett remains the CEO of Berkshire to this day, and his best friend and long-time investment partner Charlie Munger is the chairman of the board.
Today, Berkshire Hathaway is a massive corporation with a market capitalization of over $400 billion and over $200 billion in revenue per year. It was the world's 5th largest publicly-traded company in 2019.
Berkshire now owns many business in their entirety, including but not limited to:
- GEICO: a very large insurance company
- BNSF Railway: a railroad company
- Dairy Queen: ice cream restaurants
- Duracell: a maker of batteries
- See's Candies: a candy company
- NetJets: sells part ownership of private jets
Berkshire also owns many other insurance companies, lots of energy companies and utilities, and several clothing companies, to name some examples.
The conglomerate is now split into divisions, including an insurance division (Berkshire Hathaway Insurance) and energy division (Berkshire Hathaway Energy).
Besides owning companies outright, Berkshire also holds over $200 billion dollars in stock investments. The biggest stock holdings at the end of 2019 were:
- Apple: $73.6 billion
- Bank of America: $33.4 billion
- Coca-Cola: $22.1 billion
- American Express: $18.9 billion
- Wells Fargo: $18.6 billion
In addition, Berkshire holds big positions in many other banks, financial companies, and airlines, to name a few.
At the time of this writing, Berkshire's single biggest holding is actually cash. Berkshire's cash position now stands at over $120 billion.
Buffett hasn't found a lot of good investment opportunities in recent years because the valuations in the stock market have been unusually high. For this reason, Buffett has been hoarding cash and waiting for opportunities to invest.
Because of his reputation and strong financial position, he often gets sweetheart deals by providing a lifeline to struggling companies. He is very likely to put this cash to good use when the next recession arrives.
Today, Berkshire Hathaway's original shares are valued at about $277,000 per share, up from less than $8 per share when Buffett started buying. That is a return of over 3 million percent.
Many of those who invested in Berkshire early on ended up becoming incredibly wealthy, just like those who invested in Buffett's investment partnerships.
Warren Buffett's greatest investment
Warren Buffett's single most impactful investment was in the insurance company GEICO.
He started buying stock in it in 1951 when he learned that Benjamin Graham was on the board of directors. Graham is the author of The Intelligent Investor, which Buffett has called the world's best book on investing.
Eventually, he sold his stock at a profit. Then he started buying again many years later and eventually gained majority control of the company in the late 1970s when the business was struggling.
Buffett ended up buying GEICO in its entirety through Berkshire Hathaway.
Today, GEICO is probably worth over $50 billion. His tens of millions of dollars invested early on have increased by at least several hundredfolds. And the operating profits from GEICO have been used to invest in other businesses.
Buffett has also cleverly made use of the "float" from GEICO and the other insurance companies that Berkshire owns. Float is money from insurance premiums that may be used to pay claims later.
Berkshire now has over a hundred billion dollars in float that Buffett uses to invest and get compounding returns.
Overall, the investment in GEICO was probably the single most impactful investment for Warren Buffett and a large part of the reason why Berkshire Hathaway became so enormously successful.
Why Warren Buffett?
Warren Buffett was not born into a rich family. But his parents were very smart and well educated.
In some respects, Buffett won the "ovarian lottery" — he was lucky to be born to good parents, in a prospering country (the US), and to become an adult during a time of enormous economic growth.
In other words, a lot of Buffett's success is due to luck. He even admits this himself. If he had been born in a third-world country to parents with no education, Buffett would not have become what he is today.
But Buffett also has unique talents and an incredible work ethic. He often worked from morning until evening reading books and financial reports.
At a time in his career, he had detailed knowledge of pretty much every publicly traded company in the US. His reading and studying gave him the edge he needed to outperform other investors.
In addition, Warren Buffett was lucky to be mentored by the likes of Benjamin Graham, and to be influenced by his friend Charlie Munger. Without those people in his life, he might not have become nearly as successful.
He also credited a course in Dale Carnegie with helping him become a more likeable person and a more successful communicator. He often says that this was his single best investment.
So, it is true that a lot of Buffett's success can be attributed to luck. But it wouldn't have happened without also coinciding with extreme talent, incredible intelligence, and massive amounts of dedicated work and effort for many decades.
Another big contributor to Buffett's wealth is that he was always a diligent saver. In fact, he has lived an incredibly modest lifestyle relative to his wealth.
For example, he still lives in the house he bought for $32,500 in Omaha in 1958.
What is Warren Buffett doing today?
Warren Buffett is now 89 years old. He is still the CEO of Berkshire Hathaway and still manages a lot of its deals and investments.
However, he hasn't been able to make any major acquisitions in recent years because valuations have been high. So, his current strategy seems to be hoarding cash and waiting for buying opportunities.
Buffett has also spent quite a bit of money and effort on philanthropy in recent years. He has given billions of dollars to the Bill & Melinda Gates Foundation and pledged to give the foundation 99% of his fortune after he passes.
Warren Buffett and his partner Charlie Munger are also still holding the Berkshire Hathaway annual meetings each year, where they spend hours taking questions from Berkshire Hathaway shareholders.
These annual meetings are often termed "The Woodstock of Capitalism" and they are attended by tens of thousands of people each year.