This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.
Happy anniversary to…well, all of us, I guess. This post marks my one-year (and five days) anniversary of being a contributor to Get Rich Slowly. It’s been a hoot.
My very first post was a report from my journey to last year’s Berkshire Hathaway annual meeting. While I didn’t attend this year’s meeting, which occurred two weekends ago, my interest in Warren Buffett’s commentary and biography hasn’t flagged. After all, I’m a Berkshire Hathaway shareholder.
The wealth snowball
This post’s Buffett lesson comes from The Snowball, the recent Buffett biography by Alice Schroeder in which she writes: â€œSince Warren looked at every dollar as $10 someday, he wasn’t going to hand over a dollar more than he needed to spend.â€ Buffett apparently was so cheap, he only washed his car when it rained so he wouldn’t have to pay for the water.
Former Washington Post heir and publisher Katherine Graham once asked Buffett for a dime to make a phone call. (Before the advent of cell phones, people had to use these things called phone booths if they wanted to make a call in public — and they didn’t even have Twitter!) Buffett only had a quarter, so the billionaire first went to get change.
Now, we all know that spending a dollar today means we won’t be able to spend it later. We may also allow that a dollar invested today will be worth more years hence, so that we not only delay gratification — we can pay for more of it.
Yet for Warren Buffett, it turns out that he was underestimating himself. From 1965 through 2009, Berkshire Hathaway stock returned an average 20.3% annually, turning $1 into $4,341. That, ladies and gentlemen, is how you become the richest person in America.
Compounding for mere mortals
But what about the rest of us? Is it reasonable to think an investment today could decuple? (Yes, that’s the word for something that has increased tenfold, and, yes, I had to look it up.) That depends on the return you earn, and how long you earn it.
Below are three charts, assuming different rates of return, initial investments of $100, $500, and $1,000 (which are more representative than $1 of the spending decisions we make nowadays), and the numbers of years the money is invested.
In these examples, the only amounts that have increased tenfold are the ones invested for 30 years and earning 8% annually, a return not quite as easy to earn these days as they were in the second half of the last century. Still, the numbers might be compelling, especially for younger folks.
A few additional thoughts about these tables:
- These numbers don’t take inflation into account. So forgoing $100 today doesn’t mean you’ll buy $1,000 worth of goods at today’s prices; it’ll likely be quite less. But as long as you earn a return that exceeds inflation, you’ll still be able to buy more in the future than you could buy today.
- While most of us don’t drop $100, $500, or $1,000 on purchases every day, I do find it informative (and occasionally painful) to annualize expenses. Spend $6 every workday on lunch? That’s approximately $1,400 a year. Your cable costing you $100 a month? That’s another $1,200. And that’s after-tax money. In other words, to spend that $1,200, you had to earn $1,600 and then pay $400 in federal and state taxes (assuming a 25% combined rate) to have that $1,200 to spend. If you put that money in a traditional retirement account, you can at least defer the federal and state income taxes (though not the FICA taxes — you still have to pay those).
- The numbers in the charts reflect a one-time investment, and not continual, regular investments. For example, if you invest $500 every month and earn an average annual 6%, you’d have approximately $500,000 after 30 years.
- If you’re closer to the day you hope to retire than the last time you pulled an all-nighter, you might be saying, â€œBut I don’t have 30 years for my money to grow!â€ That may be true for the money you need in the first several years of your retirement, but if you live to the average life expectancy (or longer), you won’t touch some of your money until you’re a decade or two into your retirement. Unless you’re an 85-year-old one-armed chainsaw juggler who smokes, you should plan on some of your money being invested for decades.
If you, like Buffett, find thinking about future values helps being frugal, print out those charts. Put them in your wallet. Wrap them around your credit cards. Post them on your computer monitor about where the â€œPlace your orderâ€ button shows up on your favorite e-shoppe. After all, as Alice Schroeder explained in an interview with The Motley Fool, the power of compounding is where the title of her book comes from:
The Snowball is from a saying of Warren’s about life being like a snowball. It is really a metaphor for compounding, for the way that things tend to grow at an exponential rate when they are rolling forward over time. So his money has obviously been like a huge snowball, but it also refers to relationships and to knowledge and all the different things that tend to grow and layer upon each other.
Balancing tomorrow and today
Despite Buffett’s famed frugality, he doesn’t recommend forgoing all of life’s pleasures. As Schroeder explained in another next segment of her Foolish interview, even Buffett recommended that you have to strike a balance between enjoying today and investing (your bucks or your brains) for tomorrow:
He said to me one time, if there is something you really want to do, don’t put it off until you are 70 years old. … Do it now. Don’t worry about how much it costs or things like that, because you are going to enjoy it now. You don’t even know what your health will be like then.
On the other hand, if you are investing in your education and you are learning, you should do that as early as you possibly can, because then it will have time to compound over the longest period. And that the things you do learn and invest in should be knowledge that is cumulative, so that the knowledge builds on itself.
So instead of learning something that might become obsolete tomorrow, like some particular type of software [that no one even uses two years later], choose things that will make you smarter in 10 or 20 years. That lesson is something I use all the time now.
J.D.’s note: While I realize that much of the discussion about compounding involves theoretical, it’s still fascinating. If you start early enough and are disciplined (and things go according to plan), you really can use the power of compounding to build great wealth. But, as Buffett points out, it’s not just money that compounds. Knowledge does, too, as do relationships and experience. The more you do to improve your life today, the better it will be tomorrow.