The Alternative Warren Buffett

Writing in the Financial Times in 2008, John Kay put Warren Buffett's success into simple perspective:

During Mr. Buffett's tenure at Berkshire Hathaway [ (NYSE: BRK-A  ) (NYSE: BRK-B  ) ], the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that -- as Mr. Buffett's have done -- your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr. Buffett the richest man in the world.

I thought about that simple -- and startling -- math while reading a short article written by Buffett himself this week in Forbes. In it, Buffett writes:

When I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I'll go back to Omaha, take some college classes, and read a lot -- I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, "Compound interest guarantees I'm going to get rich."

Buffett's net worth today, according to Forbes, is $44 billion. Some quick math, then: Since 1955, his net worth has compounded at a rate of 25.08% a year.

That got me thinking: What if the skinny kid from Omaha with $127,000 in 1955 didn't spend the next half-century devoted to stock-picking, business-building, and market-beating? What if Buffett instead did something more traditional with his money, like put it in an index fund, Treasury bonds, gold, or cash? You can imagine a few "alternative" Buffett scenarios. And like Kay's statistic, they show how powerful compound interest can be over time.

Scenario one: S&P 500 index fund
Including dividends, $127,000 invested in the S&P (or a re-created equivalent) in 1955 would be worth $31.7 million today, which works out to an annual return of 10.17%. That gives us a good proxy to measure Buffett's market outperformance: Of his $44 billion net worth, about $43.97 billion came from so-called "alpha," or returns in excess of the benchmark.

For more perspective, Bloomberg has a new tool that tracks the daily net worth change of the world's billionaires. It shows Buffett's net worth changed by $328 million yesterday alone, or more than 10 times what his entire net worth would be had he invested in the S&P in 1955.

Scenario two: 10-year Treasury bonds
$127,000 put in 10-year Treasuries in 1955 would be worth $3.9 million today, for an average annual return of 6.2%.

For perspective, if Berkshire paid out half its net income as a dividend, Buffett would earn $3.9 million every 27 hours, roughly.

Scenario three: Half stocks, half Treasuries
Split the difference between the first two scenarios, and you get a pretty average American portfolio. How much would $127,000 split between stocks and Treasuries in 1955 be worth today? $17.8 million, for an annual return of about 9% -- and $43.98 billion less than Buffett actually earned.

Scenario four: Gold
$127,000 plunked into gold in 1955 would be worth just over $6 million today, the vast majority of which came in the last few years alone. That's about a day and half of Berkshire's hypothetical dividend, if you're keeping track.

Scenario five: Cash under the mattress
$127,000 in cash in 1955 would be worth... $127,000 today. There are a couple of ways to put that in perspective. One, inflation would whittle the amount down to about $15,000 in today's dollars. Two, a net worth of $127,000 today puts you at exactly the 50th percentile of American households -- just barely average.

You might think it's unreasonable to assume cash is stuffed under a mattress -- or some other way to earn a 0% return -- but it's sensationally popular these days. Americans now have over $10 trillion in bank deposits, up $760 billion in the last year alone.

Lesson learned
Now, these figures are rough estimates at best. It's impossible to know how things like spending and taxes would have actually affected Buffett's "alternative" net worth.

What they should demonstrate, however, is how staggeringly powerful even small differences in returns add up over time. You should not expect to earn Buffett-like returns over the next 50 years. In fact, you almost certainly won't. But the difference in earning 3% a year versus, say, 7% or 9% a year, compounded over a few decades, is no less than life-changing.

When you look at where most new money is going these days -- lots going into bonds yielding close to nothing, and little going into stocks that still offer good returns -- you see at least one reason why Buffett is abnormally successful: He understands and appreciates the power of compounding returns better than most. That simple arithmetic, as Kay might say, made him the richest man in the world.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (27) | Recommend This Article (78)

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  • Report this Comment On March 30, 2012, at 11:25 AM, whatsthepoint wrote:

    Great article, Morgan!

    What I actually take away from this article is that putting money in a broad-based stock index fund is actually not a bad idea.

  • Report this Comment On March 30, 2012, at 11:29 AM, thenoffya wrote:

    Your math is wrong. 44 Billion minus 30 Million is 43.97 Billion. Doesn't make a huge difference in your argument though, and really only strengthens it. You made the same mistake in scenario 3.

  • Report this Comment On March 30, 2012, at 11:31 AM, TMFMorgan wrote:

    ^ You're right. Darn big numbers! We'll have it fixed soon.

  • Report this Comment On March 30, 2012, at 12:07 PM, DukeTG wrote:

    I will be sure to keep this in mind after I win the Mega Millions jackpot this evening.

  • Report this Comment On March 30, 2012, at 12:15 PM, ncredbear wrote:

    While I definately agree with the sentiment of the article I believe your comparisons are somewhat misleading and some might say down right wrong.

    Using your comparison philosophy, I invested $2000 in an IRA in 1992 and now 20 years later I have $100,000. Looked at that way I was a fantastic investor because I averaged a 19.7% return every year. What is missing though is that I added an additional $2000 every year that came from sources outside my investing. In my case these extra payments came from my salary. The same is true of Buffet he did not grow his $127,000 to $44 Billion, he added additional funds along the way. In his case part was due to straight cash salary and part was that he was given stock as part of his compensation.

    Now this is not taking anything away from Buffet he still has been a phenomanal investor who results don't need skewing.

  • Report this Comment On March 30, 2012, at 12:19 PM, TMFMorgan wrote:

    <<The same is true of Buffet he did not grow his $127,000 to $44 Billion, he added additional funds along the way. In his case part was due to straight cash salary and part was that he was given stock as part of his compensation>>

    Fair point ... to a point. Buffett has never taken more than $100,000 in salary (and I'm sure he spends much more than that annually), and I'm 99% sure he's never taken stock compensation (looking into that). In short, I think it's roughly fair to assume that his entire net worth is the result of investment returns.

  • Report this Comment On March 30, 2012, at 12:32 PM, Mega wrote:

    I agree that his growth in net worth since starting Berkshire is almost entirely the result of investment returns.

    Before that, a substantial part of his growth in net worth came from fees for managing other people's money in his hedge funds. (Which given his performance were well deserved.)

  • Report this Comment On March 30, 2012, at 2:08 PM, villainx wrote:

    I think worthwhile in this analysis is if Buffett dumped his early stake into real estate of some sort.

  • Report this Comment On March 30, 2012, at 2:34 PM, polenium wrote:

    Buffet's father was a member of Congress. He didn't get rich picking stocks. He got rich on inside information.

  • Report this Comment On March 30, 2012, at 2:37 PM, TMFMorgan wrote:

    His father died before he took over Berkshire. So there's that.

  • Report this Comment On March 30, 2012, at 3:01 PM, fluffheadsr wrote:

    "I will be sure to keep this in mind after I win the Mega Millions jackpot this evening."

    B.S. i'm winning 650 million today and i won't have to worry about investing after that.

  • Report this Comment On March 30, 2012, at 3:26 PM, Merton123 wrote:

    Warren Buffet had the advantage of investing insurance premiums dollars into companies as investments. He basically was able to use leverage (insurance premiums) to achieve very good returns. The other insurance companies invest in bonds to create cushion if an loss occurs and they have to payout to their customers.

    Morgan does make a good argument about compounding interest over the long run should provide a good return. To achieve returns greater then an index fund probably requires a person to become self employed. Warren Buffet was self employed. Bill Gates was self employed.

  • Report this Comment On March 30, 2012, at 4:17 PM, Ravi786 wrote:

    Morgan,

    You forgot one important detail. Warren Buffett always invests in value companies and dividend paying companies. So it instead of using a index fund, you need use value index fund (say like VTV) and dividend index fund. What would be the present value of 127K invested in value index find and divident index fund in 1955.

  • Report this Comment On March 30, 2012, at 4:27 PM, TMFMorgan wrote:

    Ravi,

    There's actually a good way to measure that. According to Jeremy Siegel's research, investing in the 100 highest-yielding S&P companies from 1957- 2006 produced a return 3.83x that of the normal S&P 500. Better, but still nowhere near Buffett's returns.

  • Report this Comment On March 30, 2012, at 7:34 PM, daveandrae wrote:

    I began my investment career on June 1st, 1998. On that day, the s&p 500 closed at a market price of 1133.

    Today, almost fourteen years later, the index closed at a market price of 1408. If the market continues to gyrate around this price level over the next two months, the annualized rate of return from the index over my fourteen year investment career (assuming dividends were reinvested and taxes were paid from another source) would be a whopping 3.5%.

    3.5%!!!

    As you can see, 3.5% is not even on the same planet as the 10.17% Mr Buffett has enjoyed over his investment career.

    The moral of my story is two fold.

    1. Even the intelligent investor must realize that common stocks are not a better buy than bonds or cash, under ALL conditions.

    2. A large portion of "10% total return" is based primarily on the reinvested dividend, which was much, much, higher in 1955 than it is today.

  • Report this Comment On March 30, 2012, at 7:54 PM, Ravi786 wrote:

    Morgan,

    Thanks for the quick comment. Your article is very interesting.

    Warren Buffett always says that he removes emotion and follows rigorous analysis while investing in stocks. So my naive thinking is that there should be some formula out there, that can match his returns if it is followed properly with discipline over the time period.

    I understand that the exact answer is difficult, can you guesstimate what the returns will be in the same time period if one invests in ""magicformula"" stocks proposed by J. Greenblatt.

  • Report this Comment On March 30, 2012, at 8:00 PM, TMFMorgan wrote:

    ^ I view the moral of your story as:

    Don't buy stocks when they trade at 30 times earnings, as they did in 1998. The end.

  • Report this Comment On March 30, 2012, at 9:42 PM, daveandrae wrote:

    ^

    1. Anyone following your advice in 1998 would have came back and sued you after the Nasdaq rallied more than 80% in 1999, too.

    2. In a 0% interest rate economy, the 2011 trailing p/e ratio of s&p 500 operating earnings was 13. Yet, 78% of active mutual funds still managed to lose money and charged "investors" a fee to do it.

    3. I've grown my five figure investment portfolio at an annualized rate of 18.3% since June 1st, 1998.

    I could go on and on, but the point is obvious. The dominant, determinant, or real world, real life, investment return, is driven primarily by the investor, himself.

    "market timing" and "price selection" which most people put the overwhelming majority of their energy into, account for less than 10% of total return, tops.

  • Report this Comment On March 30, 2012, at 10:25 PM, bordereiver wrote:

    You woke me up. My equity investments are doing quite will thanks to help from you at Motley Fool and Morningstar, but my wife's bonds are going absolutely nowhere. Already put a third in good solid dividend stocks (PG,JNJ,PEP,GE, BBL,RIO), and will do more.

    But as TMFMorgan points out I can't chase the stocks that don't make sense.

  • Report this Comment On March 31, 2012, at 1:40 AM, sonoftherepublic wrote:

    As I have stated on other posts I think much of what Buffet and Munger do is lost on many of the spectators who watch them and try to discern their methods and results.

    Comparing BK to lets say an S&P 500 is comparing and actively managed, publicaly traded hedge fund to a passively managed Index fund.

    Buffet and Munger use options to hedge price fluctuations affecting BK - alot of options !!!!!which in themselves are hedged with cashless collars ( a series of puts and calls used to defray the cost of of the original cost of the first option.)

    Buffet and Munger work inside BK making it a better holding company - Index funds offer no such interaction. One should be able to add to their position in the index with money made from their employment activity to at least approach a level playing field of comparison. Even then it is not accurate - I find this article moot in its helpfulness

  • Report this Comment On March 31, 2012, at 4:21 AM, Monevator wrote:

    Hello Morgan,

    I love your article, of course. (I regularly cite your articles on my own website, you're a true original thinker on finance IMHO.)

    However here I think you've made a common mistake of overlooking the fact that in the early years Buffett's partnerships were straight-up hedge funds.

    He was scything off excess returns from his partners, which hugely ballooned his wealth in the pre-Berkshire years.

    See this article:

    http://monevator.com/2011/09/01/how-did-warren-buffett-get-r...

    This doesn't dismiss my admiration for Buffett, personally -- and his hedge fund days were only so successful because his returns were out of the park, of course! :)

  • Report this Comment On March 31, 2012, at 9:41 AM, Merton123 wrote:

    Benjamin Graham in his book "Intelligent Investor" states that for the "enterprising investor" to outperform the broad indexes they have to do something different then the rest of the investors. Warren Buffet invested differently then the rest of the investors so was able to achieve higher returns then the other "enterprising investors":

    1. Geico - He used insurance premiums (float) to buy companies

    2. He bought the entire company so he didn't have to worry about earning growth. He was able to buy companies as if they were bonds.

    How does Berkshire Hathaway indepedent stock holding performance compare with the S&P 500 index? Right now Berkshire hathaway ownes Coke, Proctor & Gamble, General Electric - mostly companies that comprise the DOW 30. So his investment performance comparing apples to apples when looking at his investment of publically traded companie is probably comparable to DOW 30 return.

  • Report this Comment On March 31, 2012, at 1:13 PM, karlm1 wrote:

    He had the advantage of being mentored by Benjamin Graham.

  • Report this Comment On March 31, 2012, at 10:07 PM, bradeoneill wrote:

    I'll bet buffet would trade it all to be 27 again. The future is yours whippersnappers. quit occupying wall street and learn how it works. you will be a lot happier in the end.

  • Report this Comment On April 03, 2012, at 4:11 PM, ayaghsizian wrote:

    Hasn't he donated north of $30 Billion to charities in the last decade. I think his real potential net worth would be over $74 Billion if he was greedy.

  • Report this Comment On April 06, 2012, at 12:36 PM, WestCoastToast wrote:

    In Scenario 1 above you referenced a calculator on another website that calculates net worth of Earth's billionaires. To quote: "It shows Buffett's net worth changed by $328 million yesterday alone, or more than 10 times what his entire net worth would be had he invested in the S&P in 1955." I may be reading that wrong but it looks like it was the change for one day. Annualizing that gave me a yearly increase rate of 272% (my calculations: 328,000,000/44,000,000,000 = 0.007455 X 365 = 272.09%.) I'm not skilled in high finance or even math, but if I'm way off, what would the annual rate be for his net worth?

    In paragraph 5, you wrote this: "Since 1955, his net worth has compounded at a rate of 25.08% a year." Big difference. Is there an error?

  • Report this Comment On April 06, 2012, at 12:43 PM, TMFMorgan wrote:

    ^ Markets move up and down at random intervals every day. One day's movements can't be extrapolated over an entire year.

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