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Warren Buffett’s Secret Formula For Wealth Creation

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Wendy Nelson

President and Founder
Wind River Wealth Advisors
Wendy Nelson : (720) 256-3986
Cheri Lucking : (307) 203-7413
Office Fax : (720) 222-5902
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Berkshire Hathaway’s (BRK/A, BRK/B) Warren Buffett and his late partner Charlie Munger are considered two of the greatest investors ever. The duo’s allocation of a large portion of their net worth in common stocks, combined with their stock-picking success, generated massive wealth for those two men and Berkshire Hathaway shareholders. As Buffett once said, “Since the game is so favorable, Charlie [Munger] and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the prediction of the ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”

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Berkshire Hathaway’s Warren Buffett and his late partner Charlie Munger are considered two of the greatest investors ever and both spoke about harnessing this tool for wealth creation. — (Photo by: Lacy O'Toole/CNBC/NBCU Photo Bank/NBCUniversal via Getty Images)

NBCU Photo Bank/NBCUniversal via Getty Images

Just looking at the long-term annualized returns on stocks, as defined by the S&P 500, illustrates the value creation of owning a piece of an operating business over other investments. This sizable advantage also applies to the real, after-inflation, annualized returns.

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Long-Term Annualized Returns: 1928-2023

Glenview Trust, Bloomberg, Aswath Damodaran

To translate this annualized performance into dollar terms, $100 invested in the S&P 500 at the start of 1928 would have grown to $787,019 by the end of 2023. Even more importantly for wealth creation, the purchasing power of this $100 in stocks grew to $44,179. Contrast this performance with the value of the U.S. dollar; a $100 bill in 1928 would now have a mere $6 in purchasing power at the end of 2023 due to the ravages of inflation.

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Value of $100: 1928-2023

Glenview Trust, Bloomberg, Aswath Damodaran

The hidden secret in this performance is compound interest. Warren Buffett’s authorized autobiography, The Snowball: Warren Buffett and the Business of Life , is a nod to the combination of time and compound interest in increasing wealth. Buffett has said, “Life is like a snowball. The important thing is finding wet snow and a really long hill.”

The reinvestment of profits inherent in owning stocks leads to exponential growth in wealth when stocks rise in value. As a concrete example, $100 growing at 9.8% simple interest for 30 years becomes $394. In contrast, $100 growing at a 9.8% compound return soars to $1,652.

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Compound Versus Simple Interest

Glenview Trust

The compound return effect also has a crucial impact on stock market and portfolio return. Hendrik Bessembinder recently wrote a fascinating paper examining the returns on 29,078 U.S. stocks from 1926 through 2023, which found that over half of all stocks, 51.6% to be precise, had negative cumulative returns. How can the stock market have excellent long-term returns while more than half of the stocks fall in value while publicly traded?

Setting aside the complex mathematical properties of strong positive skewness in stock returns, a simple example of long-term positive compound returns provides the answer. Take a portfolio of just two stocks selling for $100 per share. The first stock grows at 9.8% annualized, while the second stock falls by 9.8% annualized over thirty years. Many would think our total portfolio would stagnate during that period since the losses in one stock would offset the other, but compound returns make our intuition incorrect. The exponential return on our positively performing company outweighs the loser. Our portfolio grew to be worth $1,657, a 7.3% annualized rate.

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The Magic Of Compound Interest

Glenview Trust

Buffett highlighted this secret of compound returns when managing Berkshire Hathway’s investment portfolio in his 1989 annual letter. He writes, “We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.” Buffett doesn’t explicitly mention compound returns, but allowing winners to run and selling your losers over a long period harnesses its power.

Charlie Munger provided another critical instruction on how to maximize compound returns when he said, “Sit on your ass investing. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.” Unrealized capital gains on stocks are akin to an interest-free loan from the government, so the longer an investor can utilize the Internal Revenue Service’s share of the gain to compound, the better.

Many assumptions must be made to illustrate the additional return needed to make up the tax payment for taking a taxable short-term capital gain on a stock. In this example, the stock is now worth $100,000 and has a tax basis of $65,000, and the investor’s short-term capital gains rate is 49.3%. Depending on how long you hold the new investment you buy with what remains of the sale proceeds after paying the tax, the latest investment needs to outperform your previous by 6% annualized for three years or 1.8% for ten years to make up for the tax payment.

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Breakeven Excess Annualized Return Needed For Short-Term Capital Gain

Glenview Trust

With the same assumptions as before, except for a lower long-term capital gains rate, the new investment purchase must outperform your previous by 3.6% annualized for three years or 1.1% for ten years to make up for the tax payment.

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Breakeven Excess Annualized Return Needed For Long-Term Capital Gain

Glenview Trust

While the variables make a difference, and there are cases where it would be appropriate, short-term capital gains should generally be avoided if the goal is to maximize after-tax wealth. Even long-term gains retain a significant hurdle for deciding to exit a winning investment in a taxable account. The conclusion should be that investors owning companies expecting to be excellent long-term should be willing to tolerate short-term underperformance to utilize the power of compound returns and maximize after-tax wealth.

While stocks have rebounded to near all-time highs again, the looming election and the typical behavior of markets during political or economic uncertainty could cause rising volatility. At these times, it is helpful to revisit the first principles of investing that time is our friend when investing in stocks. Investors should retain enough safe assets, like cash and bonds, to ride out any market volatility and allow the compounding effect of stock investments to do their magic over the long term. Leaving the last word to Warren Buffett, “American business will do just fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game heavily stacked in their favor.”

By Bill Stone, Contributor

© 2024 Forbes Media LLC. All Rights Reserved

This Forbes article was legally licensed through AdvisorStream.

Wendy Nelson profile photo

Wendy Nelson

President and Founder
Wind River Wealth Advisors
Wendy Nelson : (720) 256-3986
Cheri Lucking : (307) 203-7413
Office Fax : (720) 222-5902
Schedule a meeting