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Warren Buffet's "Snowball Investing" - Applying The Simple Rule Of Compounding Interest

By Edited Feb 29, 2016 0 0

The Oracle of Omaha: Warren Buffet

How to invest in the stock market

Warren Buffet, the Oracle of Omaha, became the richest man in the world in 2008, and he has remained in the Forbes top 10 list of the wealthiest ever since, standing on the same podium with Bill Gates. He is the CEO of Berkshire Hathaway, the holding company – the “parent” company – of all his investments in the myriad of businesses that he is a part-owner of. He either sits as a director in these companies’ board of directors or commands a big influence in the managerial aspects of these corporations.

This year, 2011, his wealth is estimated to be worth $50 billion – that’s 5 with 10 zeros after it! I know that you would be asking how in the world did he amass this large amount of money. He might answer the question with this – “You know kid, you just have to learn and apply the simple rule of compounding.” Upon hearing this, our jaws might drop. “What?! Is that all?!”

Yes, it’s that simple. But, the actual application of this rule might be hard for us to do considering that some of us want to be rich in two year’s time, three year’s time, blah, blah, and blah – quick money. This is not Warren Buffet’s case. To tell you the truth, it took him more than 35 years to reach the $50 billion net worth mark. Unlike Bill Gates and Carlos Slim Helu (the present richest man), who engage in the actual selling of physical products – computers and telecommunication services and merchandise, Warren Buffet made his fortune by buying stocks and holding these for a loooooong time. He does not get excited with the gyrations of the stock market and sell when the stock prices are high. In fact, he buys stocks when the stocks market is in shambles – the perfect time to invest in stocks, as he puts it.

When companies are in the brink of collapsing, when stock prices are at their lowest, and when business directors are starting to get their hands on bankruptcy forms, Warren Buffet shifts gear and drives his investment machinery. He buys and buys stocks.

Buying considerable amounts of shares of stocks of a company gives you an opportunity to either sit as board of director, be elected as the company president, or work your way up until you become the company’s chief executive officer (CEO). With Warren Buffet having a large stake in the companies that he had bought stocks from, he has control now on how to turn these companies around by sheer force of managerial will, wit, genius, and influence. This is what he did to Berkshire Hathaway, GEICO, the Washington Post, and General Re, and many others. Although some setbacks prevented him from maximizing the respective earning potentials of some of these companies, his track record definitely cemented his place as one of the richest man in the world.

Now what’s compounding (termed also as compounding interest) got to do with this? Before we go any further let’s learn the definition of compound interest:

“Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding.” – Wikipedia

Although we usually relate compounding interest to banking transactions. We can also apply this compounding concept to stocks.

For the following explanations, let’s use:

1) “Interest” Earned = The difference between the present year value of a stock and the value of the stock when it was initially purchased.

2) “Principal” Investment = The total value of the stocks purchased in a given year.

To illustrate the application of compounding to Warren Buffet’s stock investments, let’s peruse this simple sample illustration of the stocks that he bought over time from different companies:

Warren Buffet's Investment Techniques
For example, he purchased 100,000 worth of stocks from Berkshire Hathaway valued at $3 in 1967, his net worth by then is $300,000. Over time, as has been his habit and investing style, he bought stocks from struggling companies. He bought 200,000 shares from GEICO worth $1,000,000 valued at 5$ per share in 1973, $2,400,000 worth of stocks from Washington Post in 1985, and 100,000 shares of stocks from General Re valued at $13 per share. He also bought stocks from Coca-Cola in 2005. By 2005, his net worth has already totaled to $30,700,000 – earned with the power of compounding interest.

Now, Warren Buffet having control and influence over these companies, he turned these struggling companies around by helping each company’s directors manage the company well and implementing guidelines that will restrain the negative effects of the financial market’s volatility. In turn, the businesses of these companies improved which would naturally lead to increased profits. Consequently, this growth in company profits will have a positive impact on the value of each share of stock of a company. As the share value increases, each share earns “interest” – the difference between the present year value of a stock and the value of the stock when it was initially purchased. This interest amount is then added to the “principal” – the total value of the stocks purchased in a given year. Thus, as interest earnings is continually added to the total value (principal) of the stocks, this will lead to the “snowball” effect. The bigger the value of your stocks, the higher would be its capability to earn big profits when these stocks are sold.

Of course, the share value of each stock will continuously dip and rise on every trading day. There are also numerous factors that will influence the value of each stock  such as the business operations performance, the capabilities of the managers supervising the operations of a particular company, and the volatility of the stock market.

However, Warren Buffet, having continuously bought large amounts of stocks over time, and continues to do, his net worth will continually increase also. This fact will continue to be true, especially if the companies continue to improve their respective business performance year after year.



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