Warren Buffett (Trades, Portfolio) once said:
“If I had $10,000 to invest, I would focus on smaller companies because there would be a greater chance that something was overlooked in that arena. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. But you can’t compound $100 million or $1 billion at anything remotely like that rate.”
While Buffett was referring to his early days of investing smaller sums, his advice contains timeless wisdom for those looking to grow their money from modest beginnings. So how can an ordinary investor make their first $1 million and then continue compounding at 50% a year?
How to make your first $1 Million
Buffett built his fortune from humble beginnings and has provided many tips over the years on how an ordinary investor can make their first $1 million.
First, start investing early with small amounts. Buffett purchased his first shares at age 11, giving the power of compound interest more time to work its magic. By starting early, you maximize the years your money can compound returns. Even investing small sums in your youth primes the pump for the “snowball effect” of compounding. As Buffett has said, “The best thing I did was to choose the right heroes.” Follow in his footsteps by developing sound investing habits early.
Next, invest in smaller, overlooked companies. Buffett attributes his high investment returns in the 1950s partly to the fact he was investing smaller amounts in tiny companies below the radar. With limited research coverage, these businesses were more prone to be mispriced. Small caps also have greater potential for expansion. Focus your time hunting in this promising area of the market, where inefficiencies still exist. Look for strong businesses with competitive advantages that have been overlooked.
Rather than spend his investment gains, Buffett continually plowed them back into buying more undervalued stocks. The reinvestment of dividends and stock sale profits turbocharges the power of compounding. Like a snowball gathering mass as it rolls downhill, reinvested earnings swell portfolio value exponentially over time. Make this cycling of capital gains into new investments a cornerstone of your strategy.
It would also be good to utilize the power of compound interest. The towering oak tree originated from a modest acorn. Market-beating returns compounded over decades are responsible for the bulk of Buffett’s wealth today. Time and high rates of return are the essential ingredients for compound interest to work its magic. Be patient and think long term. Maintain discipline to stay invested through ups and downs. If you sustain high returns, even modest sums compound dramatically thanks to the snowball effect.
Further, Buffett’s frugal lifestyle allowed him to funnel growing amounts of savings into investments. Cut discretionary spending and avoid lifestyle inflation. Scale back your consumption to free up capital. The more you can save and invest, the faster compounding can accelerate. Think of each dollar saved as added "snow" to make your investment snowball bigger.
Finally, take Buffett’s lead in committing to be a continuous learning machine. With experience comes wisdom in evaluating companies and opportunities. Learn from your own and others’ past mistakes. Build your circles of competence over a lifetime. Hone your investing craft day after day. The longer you can practice successful investing habits, the greater your wealth compounding will be.
Compounding at 50% per year: Buffett’s strategies
Once an investor has made their first $1 million, Buffett provides guidance on how to continue compounding at extraordinary rates. He explains why this is feasible with smaller amounts but becomes more difficult as portfolios scale up.
First, Buffett readily acknowledges it has become much harder for him to generate ultra-high returns on the immense pools of capital Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) manages. His early 50%-plus annual returns are unlikely to be repeated on the billions the conglomerate invests today. There are diseconomies of scale at work. As the snowball gets gigantic, fewer new opportunities exist that can move the needle.
With a smaller sum, like $1 million, an investor has a wider menu of promising investments to choose from. Small caps with market values under $2 billion are fertile hunting grounds. There are more undiscovered gems and inefficiencies among companies below Wall Street’s radar. High growth prospects also favor small upstarts versus mature large caps. Greater flexibility and a plethora of options make the potent 50% return goal achievable.
Futher, continually hunt for mispriced securities. Earning extraordinary returns requires finding pockets of mispricing within the market. Buffett stressed tirelessly searching for securities selling well below their intrinsic value, where the risk-reward skew was dramatically in his favor.
The key is digging where others are not looking. Buffett said, “I like finding things where there is very little competition. I like businesses I can understand.” Finding just a few hidden gem investments with huge upsides can earn outsized returns.
Consistently uncovering just a handful of overlooked opportunities each year and concentrating your capital on those can earn the types of remarkable returns Buffett achieved.
The upward spiral of compounding returns
When compounded at a high rate over decades, portfolio growth starts slowly, but then accelerates rapidly in a steep upward curve. Maintaining high returns on growing capital creates a flywheel effect.
For instance, a $100,000 portfolio compounding at 50% annually is worth $1.3 million after just five years. After 10 years, it snowballs to $25 million. The enormous absolute gains in later years bring portfolio values into the stratosphere thanks to the unstoppable power of exponential compounding.
This runaway compounding exemplifies Buffett’s quotation: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Keeping up a high savings and reinvestment rate over an investing lifetime can achieve similar incredible results.
The power of decades of sustained high returns
While generating over 50% returns is unrealistic for larger portfolios, maintaining well above-average returns for decades and reinvesting the gains is proven to build tremendous wealth over time.
Buffett generated the bulk of his fortune after his 50th birthday, demonstrating the awesome power of sustaining successful investing behavior over an entire lifetime. He said, “You want to be greedy when others are fearful. You simply have to stick around long enough to see the cycle through.”
Receiving market-beating returns for over half a century put the compounding snowball effect on autopilot in Buffett’s favor. Replicating even a fraction of this lifetime investing success can grow substantial wealth.
The challenge of finding opportunities at scale
Buffett admits achieving 50% returns would be theoretically possible on $1 million today by investing in micro-caps and obscured situations. However, he acknowledges it would become progressively more difficult at larger portfolio sizes.
Finding enough smaller, off-the-radar opportunities to generate sky-high returns on $100 million, $1 billion or $100 billion is unrealistic. There simply are not enough hidden gems to significantly move the needle on vast sums of capital.
This conundrum explains why Buffett eventually evolved Berkshire Hathaway's strategy toward higher-quality companies, which earn strong returns on capital but at a slower pace. Nevertheless, his advice shows that with focus and perseverance, an ordinary investor can utilize the same principles that worked extraordinarily on smaller scales.
The power of compounding your way to wealth
Buffett built his vast fortune by starting early, living frugally, reinvesting gains and developing his investing expertise over decades. He capitalized on the immense power of compound interest.
While admitting returns diminish with larger sums, Buffett guarantees that even today, he could compound $1 million at 50% annually by investing in overlooked, smaller companies. Though difficult, his blueprint proves earning extraordinary returns is achievable by starting small, sticking to high-return investments and letting compound interest work its magic over an investing lifetime.
