Warren Buffett is one of the richest and most successful investors of all time. Starting at the age of 11, the now-billionaire stock picker leveraged the power of compounding over the long term to exponentially grow his fortune to around $112bn (£90bn). So how does this strategy work? And how can I use it in my aim to get rich too?
Investing like Warren Buffett
The secret sauce behind Buffett’s success is not actually a secret. Every year the ‘Oracle of Omaha’ publishes a letter explaining his strategies and methodology for investing in the stock market. And the theme is pretty clear – buy wonderful businesses at fair prices and hold them for the long run.
The last part is critical here since the compounding effect of investing takes a long time to yield tangible results. It’s a snowball effect. Starts off small, then gets exponentially larger.
Let me demonstrate. Say I start with a £1,000 portfolio that matches the historical performance of the FTSE 100. Including dividends, that’s an average annual return of around 8%. After year one, my returns equate to £80, bringing my total portfolio value to £1,080. But in year two, I’m now earning 8% on my original amount and the extra £80, making the gains equal to £86.40.
The portfolio value is now £1,166.40. This compound effect continues each year, getting larger and larger until, after 30 years, the initial £1,000 is worth £10,062.66! This simple investing trick is how Buffett amassed such a fortune in the stock market.
Picking the right stocks
Matching the performance of an index is pretty straightforward. Today, investors simply need to buy a low-cost exchange-traded fund (ETF) that follows an index like the FTSE 100. Personally, I prefer to take a different route.
By picking individual stocks, it’s possible to beat the market, achieving a higher annual return and accelerating the compounding effect. In fact, this is precisely what Buffett means when he says to buy wonderful businesses. But what makes a company “wonderful”?
In the short term, predicting the movement of share prices is near-impossible. But over the long term, they follow the underlying value and performance of the business. There are a lot of factors that influence corporate success, including a bit of luck.
But looking at the most successful companies today, a clear trend emerges. Each one established a collection of competitive advantages that enabled them to capture and retain market share of their respective industries.
Stock picking like Buffett is a skill that takes time to master. And it’s not suitable for everyone. But it does open the door to a potentially explosive performance. So much so that a £1,000 portfolio growing at 12% for 30 years would be worth just under £30,000 – almost triple what following the FTSE 100 would have achieved!