Warren Buffett’s 3 Rules That Built His Wealth & Can Do the Same for You
Written by
Ellie Diamond
Edited by
Amber Barkley
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At 94 years old, Warren Buffett is the definition of a self-made billionaire. He bought his first stocks for $38 each at age 11 and sold them for a total profit of $12. By age 14, he had saved enough from his $175-a-month paperboy job to invest $1,200 in real estate.
Buffett is now worth more than $168 billion, and countless people have asked him how to repeat his success. Here is his core advice, which consists of three basic rules for investing.
Understand Your Investments
Buffett has followed the same strategy throughout his career: Buy only investments you understand. In his 1996 letter to Berkshire Hathaway investors, he wrote, “You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
In other words, invest in a company only if you understand how it makes money. That advice might be more challenging today, with many promising companies doing highly technical, specialized work. Plus, only a select few people have Buffett’s business savvy.
Fortunately, there’s an easy way to expand your competence circle: Get advice from a trusted professional. Think of it as a competence Venn diagram. If they understand the available options and how those options relate to your needs, they can help you choose the right investment products.
Start as Early as Possible
People often interpret this advice as “start young.” That’s solid advice, but it’s OK if it doesn’t apply to you. Starting your investment journey at 35, 45 or 55 — or later — is better than not starting at all. Let’s dig into why that is …
Compound Interest
The earlier you start, the more time you have for interest to compound. Compound interest happens when money in an investment or savings account earns interest, which goes back into your account. Your balance is higher, generating more interest, which also becomes part of your balance, so you earn even more.
Doing the Math
Say you put $1,000 into an investment account earning 9.4% a year — the average rate of return over the past century, all else equal.
By year five, your $1,000 has turned into approximately $1,500 as the interest builds on itself. Even if you put nothing else into your account, that money will continue generating interest, which generates more interest. By year 20, you’ll have over $6,000.
Now, say you give that money 40 years to grow. That’s double the amount of time for the interest to compound, but you’ll have more than double your 20-year balance: $36,365, or more than six times as much.
Contribute to your account consistently, and your money will grow even more. Add just $100 each month, and you can expect a balance of almost $500,000 in 40 years, assuming a relatively stable market.
Find Promising Small Businesses
When Buffett first started investing, he put smaller sums in smaller companies. Smaller organizations often have more affordable shares and a lower barrier to entry. Also, as Buffett said in a 1999 Berkshire Hathaway meeting, “There’s more chance that something is overlooked in that arena.”
The investing world refers to these smaller-scale stocks as “small cap,” but their potential is big. In fact, according to MSCI Research, “Small-cap firms have historically outperformed larger ones, especially after recessions and over longer holding periods.”
Investing always comes with risk, which can be higher if the small company you pick is also new and unproven. But there’s also the chance of getting in on the ground floor with a big winner.
It’s not a get-rich-quick scheme, Buffett warns. Gains take time, and the market can be volatile.
“You’ve got to be prepared, when you buy a stock, to have it go down 50% — or more — and be comfortable with it,” he told investors at Berkshire Hathaway’s 2020 annual meeting.
If you pick small, pick confidently and give it as much time as possible, you’re following Buffett’s rules to the letter.
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