Warren Buffett doesn’t make money like he used to. For decades, he earned average 20% returns for his company Berkshire Hathaway. But in recent years, his company hasn’t even outperformed the S&P 500.
Lack of skill or knowledge isn’t the reason for these lower returns. Rather, Berkshire is now one of the largest companies in the world. Investing sums in the billions makes discovering inefficiencies and undervalued securities tricky.
Smaller investors don’t have such issues. Buffett claims those working with a million-dollar portfolio or less can produce outsized returns in the stock market.
As a retail investor myself, I think his ‘million dollar’ rule is incredibly important to pay attention to for anyone wanting to earn big income from stocks.
Big compounding
The quote I’m referring to comes from a 1999 Berkshire Hathaway meeting. A shareholder asks Buffett his thoughts on managing smaller amounts. He answered that he knew several people who could “compound $1 million at 50% per year”.
A 50% return would be truly extraordinary. Average returns for US stocks are around 10% a year. Even high-achieving value investors probably don’t aim higher than 15% on average.
But 50% is little short of ridiculous. Even a £1,000 starting stake compounding at 50% for 20 years would turn into £3.3m. Buffett believes these returns are possible with the right investing strategy.
However, he also said it would not be possible to “compound $100m or $1bn at anything remotely like that rate.”
One million
In other words, it’s hard to find value with large investments. One issue is ‘market impact’. Simply, a purchase distorts the price when a buyer is moving around so much money. Another problem is a billion doesn’t give someone a few stocks, it gives them entire companies!
A portfolio below one million dollars is smaller and more agile. Buffett’s rule of thumb claims this amount is ideal for finding these big-earning opportunities.
He added: “I think working with a very small sum, there is an opportunity to earn very high returns.”
Leaving aside him calling $1m a “very small sum”, I believe this highlights how much opportunity there is for smaller investors.
So how would he go about earning these outsized returns? Well, to start with, he recommends looking at smaller investments and finding “arbitrage opportunities”. He goes on to discuss investing within one’s area of competence too.
Life-changing sum
Personally, I’m not following this blueprint rigidly. Buffett’s investment style might focus on fewer stocks and less diversification. This increases my chances to lose money. I’d want more safety than a portfolio geared around targeting huge returns.
Instead, I view this advice as inspiration. If one of the best investors of all time sees such inefficiencies in the markets, it gives me confidence that outsized returns are possible.
And I wouldn’t need to achieve anywhere near 50% to make a life-changing sum of money.
