Currently, at 90, Warren Buffett has a net worth of more than $81 billion.
A large portion of that was accumulated after his 50th birthday and $70 billion came after he qualified for social security benefits in his mid-60s, writes behavioural finance expert Morgan Housel on CNBC.
All this prompt a natural question. How did he get so rich?
Warren Buffett: A thought experiment
At the age of 10, Buffett began to seriously invest. By the time he was 30, he had a net worth of $1 million or $9.3 million adjusted for inflation.
Housel wonders in his article, what if Warren Buffett spent his teens and 20s exploring the world and finding his passion and then by the age 30, end up with a net worth of $25,000?
If he still went on to earn the extraordinary annual investment returns he's been able to generate — 22% annually — but quit investing and retired at 60 to play golf and spend time with his grandchildren, the rough estimate of his net worth would be $11.9 million, which is 99.9% less than his actual net worth ($81 billion.)
All of Buffett's financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years.
That's how compounding works. Think of this another way: Buffett is the richest investor of all time. But he's not actually the greatest — at least not when measured by average annual returns.
Jim Simons, founder of the hedge fund Renaissance Technologies, has compounded money at 66% annually since 1988. No one comes close to this record. As we just saw, Buffett has compounded at roughly 22% annually, a third as much.
Simons' net worth is around $23 billion. He is 72% less rich than Buffett.
Why the difference, if Simons is such a better investor? Because Simons did not find his investment stride until he was 50 years old. He's had less than half as many years to compound as Buffett.
Had Simons earned his 66% annual returns for the 70-year span Buffett has built his wealth, he'd be worth — $63,900,781,780,748,160,000.
Always consider compounding potential
Many people say that the first time they saw a compound interest table (or one of those stories about how much more you'd have for retirement if you began saving in your 20s versus your 30s) changed their life.
But it probably didn't.
What it likely did was surprise them, because the results intuitively didn't seem right. Linear thinking is so much more intuitive than exponential thinking.
If you are asked to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it's 72). Instead, if you are asked to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it's 134,217,728).
The danger here is that when compounding isn't intuitive, we often ignore its potential and focus on solving problems through other means — because we're overthinking, but because we rarely stop to consider compounding potential.
Good investing isn't about earning the highest returns
There are books on economic cycles, trading strategies and sector bets. But the most powerful and important book should be called "Shut up and Wait." It's just one page with a long-term chart of economic growth.
The practical takeaway is that the counter intuitiveness of compounding may be responsible for the majority of disappointing trades, bad strategies and successful investing attempts.
You can't blame people for devoting all their effort to trying to earn the highest investment returns. It intuitively seems like the best way to get rich.
But good investing isn't necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can't be repeated. It's about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That's when compounding runs wild.