Warren Buffett has offered a lot of solid advice through the years. Some of it is summed up in simple one-liners from the myriad of speeches and interviews he has given over the years. However, some of his best advice is found in the pages of his annual shareholder letters, which are always filled with amazing words of wisdom. His 2012 letter in particular contained what I would consider his best wealth-building advice, as he hammered home his investing preference, which was to buy productive assets.
Surveying the field
In that letter, Buffett discussed the three types of wealth-building choices we can make. In a sense, these choices represent a ladder we need to climb in order to build lasting wealth.
Most of us who have a little extra money in our pockets start on that first rung by putting that money into currency-based investments. These investments include so-called "safe" investments like bank deposits, bonds, money market funds, and even mortgages. These investments appear safe because of the income we receive, however, after taxes and inflation, we barely break even, according to Buffett.
Those of us who have a little more money tend to use it to buy things that we hope to someday sell for a higher price. These assets don't produce anything of value, which is why Buffett calls them unproductive assets. Topping the list of assets in this category is our house, however, beyond that gold, certain types of stocks and even works of art are considered nonproductive assets by Buffett. These are assets that could one day increase in value, but are really more like a lottery ticket.
Unfortunately, when it comes to building our wealth, most of us never get past the first rung, and those who do tend to get stuck on the second rung. The problem with that is that neither group can actually build real wealth. Instead, the secret to wealth building is found in the third rung of buying productive assets. Here, Buffett includes things like stocks, businesses, farms, and real estate. Sadly, few of us make it to the top, where real wealth can be made.
Producing lasting wealth
Most of us think the key to building wealth is found when an asset we buy appreciates in value. That, however, is only part of the story, and it's why so many get stuck on the second rung of the ladder. The key to building lasting wealth is to own an asset that continually produces more value. This is an asset that grows in value because its profits can be reinvested to grow even more value.
Buffett gave a really great example of productive assets in his shareholder letter this year. In that letter, he told the story of a farm he bought in Nebraska in 1986. He bought the 400-acre farm at a bargain-basement price. It was an asset that produced corn and soybeans each year that could be sold to earn around a 10% annual return at that time. However, it had the potential to do even better as productivity and crop prices improved. And improve they did, as 28 years later, the farm's earnings had tripled in value so that the farm was now worth five times what Buffett had paid.
In this case, Buffett wasn't hoping that some greater (small-f) fool would come along and offer him more than the price he paid for the farm. Instead, Buffett's wealth was built as the farm produced products that could be sold. That income could be reinvested into new machinery that would make the farm even more productive, so that even more products could be grown and sold. In addition, Buffett could have take some of the excess income and used it to buy additional farms, other businesses, real estate, or invested it in the stocks of productive businesses. It's the compounding of the income as it's used to buy additional assets that produces lasting wealth.
Most of us probably don't have the capital to buy a farm or a business -- yet. What we can do, however, is to take that next step up the ladder and start buying assets that produce value instead of trying to buy lottery tickets in an attempt to get rich quick. We can join Buffett in buying stocks for the long term, which are pieces of real businesses that will produce real wealth over time.
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