A Lesson About Compound Returns From Warren Buffett

The law of compounding returns isn't a secret, but it's nevertheless a difficult subject to get one's head around. None other than Albert Einstein once referred to it as the Eighth Wonder of the World.

Yet, while it may be hard to conceptualize the law of compounding returns, it isn't difficult to show why it matters so much for investors. One of the best places to see this, as Gaby Lapera and John Maxfield discuss on this week's episode of Industry Focus: Financials, is the first page of Berkshire Hathaway's (BRK.A 1.18%) (BRK.B 1.30%) annual shareholder letter.

Listen in below to learn what Warren Buffett has taught Gaby and John about investing.

A full transcript follows the video.

This podcast was recorded on March 6, 2017.

Gaby Lapera: Speaking of someone who has had a very long life, Warren Buffett. Exciting news from Omaha this week. He released his long-anticipated investor letter that he does every year. That is something that's ... I don't know how to describe it. It's like the Great American novel of American investing that gets written every year. If you look back at past ones, it's just this beautiful collection of investing wisdom from one of the best investors ever.

John Maxfield: If not the best.

Lapera: I know you were really excited about this, Maxfield.

Maxfield: I was. I think that's a great way that you framed it. It's not just that it's, maybe, the most valuable document that has ever been written about investing, which, I think it is, but it's a living document. He's adding to it each year. So we can not only see what he says each year, but we can see how his thought process evolved. For an individual investor, you just couldn't have a more valuable document to study than his letters.

Lapera: That's so true. For all you millennials out there, it's like Harry Potter for investing, except it doesn't end. At least I make myself laugh, and you, which is good. So one of the things that characterizes this letter is that the first page always has all the returns that Berkshire has had since 1965, when Buffett took over Berkshire. Do you want to expound a little bit on what's going on there?

Maxfield: Let me start out with a slightly different thing. One of the things that when the letter comes out, somebody like me reads immediately. Other people in the media industry do the same thing. What you're doing is looking for those pithy quotes, or what he has to say about stuff like the American economy or stuff like that. But I think one of the things that's really important, it's not only that investors should read his letter -- I honestly think that investors should always read his letters -- but it's also about how you read them. You don't want to just fall into that habit of going through and superficially picking out the favorite pithy quote that he had to say, or the five awesomest quotes that he had to say, or what he had to say about politics or the American economy. You really want to sit down and switch your thought process from that instinctual system one, which is how they refer to it in behavioral finance, into more of that calculated, slower thought process, where you're actually thinking and analyzing it. When you think about Warren Buffett, I think it's really important that while we can all sit around and say, "This guy is the most successful investor," I mean, as far as I know, and I've read quite a bit about investing, he's the most successful investor over such a long stretch of time of all time. But that doesn't mean that you should suspend your critical thought process even when reading Warren Buffett's letters.

Lapera: Not at all. I think one of the best things I picked up from college, and that helped me get successfully through grad school, was marking up every single thing that I read. I know this must drive librarians crazy, and I'm so sorry about this -- I only do this to books that I actually own, but I take a pen or pencil and I mark every page. So every time that someone says something interesting or something I want to fact-check later, I circle it, I have my own little set of symbols and notations for what I think is actually going on, and at the end of each chapter, I like to give a little summary of the most important points. And at the end of the book, I go back and write down what I thought the best things were, or what were things that I disagreed with, and think on them some more.

Maxfield: Yeah. It's funny, when you were explaining that, there are a lot of people who talk about the process of reading, and a lot of really good readers apply a very similar process to that. So, now, let me answer your first question, Gaby. On the very first page of Warren Buffett's letter, it compares the performance of Berkshire Hathaway since 1965, which is the year that he actually took over the company, until today, and it looks at the performance of Berkshire Hathaway, both the growth and book value per share, the growth in its market value of its actual shares on the exchanges, and it compares that to the S&P 500. And what I love about this first page is, the law of compounding returns, one of those things that is so difficult to get your brain around, because it's just a difficult thing to define. Albert Einstein, who I think we can all agree was a pretty smart guy -- right, Gaby? Do you agree that Albert Einstein is smart?

Lapera: Sure, he's OK. 

Maxfield: Yeah. He calls that the Eighth Wonder of the World. So Albert Einstein says this is a difficult concept to understand. But the first page on Warren Buffett's letter really drives home, even if you can't understand it, how incredibly powerful compound returns are. Let me put this into perspective. Over that 52-year stretch, Buffett has averaged a 20.8% annualized gain on Berkshire Hathaway stock. Now that's an annualized gain. Over that entire period, he's earned nearly a 2 million percentage return on his investors money. What that translates into is, a $10,000 investment in Berkshire Hathaway in 1965 -- which, if you factor inflation into the equation, that's basically enough to buy a BMW 5 Series, a nice car but nothing ridiculously fancy -- that transformed that amount of money into $88 million, i.e., generational wealth for most families.

Lapera: That's crazy.

Maxfield: Isn't it? It's just such a good example. And the other thing that really drives this point home about the power of compounding returns -- to put that in perspective, while Buffett has returned to 2 million percent over that time period, the S&P 500 has returned 12,700%.

Lapera: That's also very impressive.

Maxfield: It is, but it's like a rounding error when you look at it compared to Warren Buffett's returns. So that second point is, even small differences in percentages over an extended stretch of time, when those returns compound, can result in a huge difference. Let me give you an example from that first page. The per-share change in Berkshire's book value per share is an annualized gain of 19%. But the same, like I was saying, the market value of its actual shares is 20.8%. So a 1.8% difference. Over that stretch of time period, that transforms that 2 million percent return all the way down to 884,000% return. So just, on a yearly basis, even though it's less than a 2% difference, over the stretch of that 52-year time period, you're looking at a 1.1 million percentage difference. The point is, compounding returns is something that you want to grasp onto as an investor and take advantage of to the greatest extent that you can.