According to Warren Buffett, there are two simple and costly mistakes most of us make when managing our personal finances. Warren Buffett of Berkshire Hathaway is the third richest man on the planet, and knows a thing or two about success when it comes to money and investing. When he first took over Berkshire Hathaway in 1964, the book value of the company stood at US$19. At the end of last year it was US$114,214 – a growth rate of 19.7% every year for 48 years! Similarly, US$19 placed in the S&P 500, an American stock market index,…
According to Warren Buffett, there are two simple and costly mistakes most of us make when managing our personal finances.
Warren Buffett of Berkshire Hathaway is the third richest man on the planet, and knows a thing or two about success when it comes to money and investing.
When he first took over Berkshire Hathaway in 1964, the book value of the company stood at US$19. At the end of last year it was US$114,214 – a growth rate of 19.7% every year for 48 years! Similarly, US$19 placed in the S&P 500, an American stock market index, would’ve only grown to around US$1,400 over that same time period.
He is a man whose wisdom should be trusted. And while he is full of investment advice, he can also be counted on to give insight when it comes to personal finances as well.
On personal finances
Buffett recently teamed up with Quicken Loans, a retail mortgage lender in the USA, to offer someone the chance to win US$1 billion for a perfect NCAA tournament bracket.
To digress a little, the NCAA tournament is a basketball tournament amongst college teams in the USA. Dozens of teams would play one another in a series of games where the winner progresses to the next round and faces another winner, while the losers pack up for home. To get a perfect NCAA tournament bracket, a person has to guess the outcome of each game correctly and according to a math professor, Jeff Bergen from DePaul University, the odds of doing so are 1 in 9.2 quintillion (or 1 in 9,223,372,036,854,780,000).
Coming back to personal finances, when Buffett went on the Dan Patrick Show (a sports show in the States) to discuss the bracket-challenge, Dan asked him a simple question: “What’s the biggest mistake we make when it comes to money?” Buffett came up with a direct, but vitally important response:
“Well, I think the biggest mistake is not learning the habits of saving properly early. Because saving is a habit. And then, trying to get rich quick. It’s pretty easy to get well-to-do slowly. But it’s not easy to get rich quick.”
So often when money and investing is considered, it’s easy to fall into the trap of thinking that saving can wait until a later date, and that the best investments are the ones that no one knows about. However, those thoughts are undeniably mistaken.
A powerful example
Consider a scenario of two people, each 25 years old, David who makes $40,000 a year and Michael who makes $80,000 a year. Each year, they get a 2.5% raise and work until they are 73. Let’s say the only difference is David starts saving 10% of his income when he’s 25, but Michael decides to wait until he’s 40, while he’s making $115,000 a year.
Let’s also err on the conservative side of things and say that money grows at an annual rate of 5% each year, which is a hair-breadth less than the average historical annual price-return of the Straits Times Index (SGX: ^STI) since the start of 1988.
The Straits Times Index has grown by an average compounded rate of 5.1% from 834 points back then to 3,055 today. And, that’s not including dividends, which could easily add another 2 to 3 percentage points to the index’s total annual return given how the SPDR Straits Times Index ETF (SGX: ES3), an exchange traded fund that tracks the Straits Times Index, carries a yield of 2.9% currently.
But either way by the time each is 50, they would’ve each taken a little more than $144,000 out of their paychecks and put it toward retirement. But when they retire at 73, do you know who would end up with more money?
Well, Michael edges ahead – but not by much. Despite earning half as much money over the course of his lifetime, David would end up with roughly only 11% less than Michael. David would have $1.27 million in savings when they retired, and Michael would have $1.43 million:
What is even more remarkable than David ending up with just slightly less money despite earning half as much in salary, is that Michael ended up having to save 60% more money than David (roughly $610,000 in savings for Michael versus $375,000 for David).
If you decide to get ambitious and say the money grows at 8.5% a year, David actually ends up with almost 30% more than Michael, with $3.7 million in savings versus $2.9 million.
What we can learn
All too often in investing people are taught, “in order to make money, you must have money,” and the stock market is only useful if you find the next big company where your money is doubled in a matter of days.
Yet as Buffett expounds, and the example above shows, the true key to becoming rich is patient saving starting today and an understanding that wealth accumulation happens over the course of a lifetime.