WARREN BUFFETT’S 7 WEALTH FORMULAS FOR AVERAGE INVESTORS
Investing doesn’t have to be complicated – following these seven time-tested principles should improve your outcomes.
Most investors recognise the “Oracle of Omaha”. Warren Buffett is one of the most successful investors in history. What is notable is the fundamental, straightforward investment principles he has followed for many decades. Warren’s wealth formulas have never depended on complex algorithms or advanced financial engineering.
This suggests that investing is simple, but not easy.
Average investors tend to overcomplicate investing. This, coupled with irrational investor behaviour, often leads to losses and frustration among investors.
Consider the following seven simple principles and formulas. Apply them to your investing, and chances are that you will experience a much better outcome going forward than what you did in the past.
Formula 1: Income – expenses = investment capital
Here, the lesson is to spend less than you earn and use the basic math of subtraction. Earn money, subtract your expenses, and the remainder becomes capital you can deploy to build wealth.
Average investors obsess over sophisticated cashflow models and budgets, overcomplicating a very basic principle. Buffett still lives in his Omaha home, which he bought in 1958.
Forget the spreadsheets and focus on widening the gap between what you earn and what you spend, redirecting the surplus to investments.
Formula 2: Low-cost index funds + decades of holding = great market returns
Buffett stated in his 2013 Berkshire Hathaway shareholder letter that a low-cost index fund is the most sensible equity investment for most investors. He reinforced this by specifying in his will that 90% of the cash left to his wife should be invested in a low-cost S&P 500 index fund.
It is ironic that Buffett included this instruction in his will, while his own company manages investments very actively. I assume he considers his wife to be an average investor rather than a sophisticated one.
Passive fund managers and index-tracking managers enjoy using these comments in their marketing materials. Before jumping into the S&P 500 now, we must remember that Mrs Buffett is likely to inherit a substantial share of Berkshire Hathaway, which is a very active investment management company.
Berkshire Hathaway did not become one of the most successful investment houses on earth by holding passive investments. Their philosophy was and still is to buy shares and whole companies and keep them for a very long period.
Read: New York Times stock hits all-time high after Buffett’s blessing
I believe that Buffett’s comment was directed at investors who invest directly in the stock market and not necessarily those who choose funds to invest in. We also know that in the US, most managers fail to outperform the S&P 500 Index.
It might be a good idea for Americans to invest in an S&P 500 tracker, given they live in USD and the size of the US market. For those outside the US, other considerations come into play, involving many decisions and choices. Index tracking investments demand very active decisions regarding region, asset classes, sectors and currencies.
From a cost perspective, I agree. One must make sure to get what one pays for, irrespective of what one invests in. I have written in the past that I am not convinced that the lowest fees guarantee the best outcome. That will only apply where exactly the same underlying assets are bought at a cheaper price.
Formula 3: Time x consistent contributions x reinvested returns = compound growth
Buffet began investing in 1942 at the age of 11 by purchasing three shares. By the age of 14, he bought a farm and started his professional investment career in the 1950s.
Since then, he has built a business worth more than $1 trillion. At 95, he remains active in his business, and given his experience and longevity in investing, no one understands better the power of consistency and duration in generating compound growth.
Over 90% of his net worth was accumulated after the age of 65. Buffett’s net worth was roughly $3 billion at age 65 and surged to over $100 billion in his 90s.
Read: The day you retire, will you rejoice or cry?
The lesson and the mathematical fact are that compounding accelerates significantly as the investment period lengthens.
Let’s pause a bit and focus on common mistakes made by the average investor:
The most common mistake the average investor makes is checking their investment values too frequently. Volatility causes anxiety, and equities tend to be volatile. This leads to irrational investor behaviour, which often cements losses.
The average investor constantly zeroes out of the three variables. They pull money during downturns (when they should be adding) and interrupt consistent contributions.
They chase “hot trends” (especially when one is “running”), thereby resetting reinvested returns.
Switch strategies every few years, restarting the time variable. Investment strategies should only change when one experiences a life-changing event.
Buffett describes the stock market as a tool for transferring money from the impatient to the patient. As investors, we must practise patience and allow all three variables to unfold uninterrupted over decades.
Formula 4: Cash flow in > cash flow out = asset (the reverse = liability)
Every rand invested should generate more rands in return. The inequality is the fundamental difference between building wealth and merely spending money.
The typical investor struggles to identify which side of the equation their purchases fall on. They finance cars and call it building credit, but the cash flow only goes outward.
Read: The illusion that property is a good investment
They buy oversized homes and claim they are their most valuable investment, yet the bond payments, taxes, maintenance, and levies consistently drain cash each month.
Which is a better wealth creation strategy: buying a R 12 million house and enjoying the lifestyle, or purchasing a R 6 million house along with two additional properties worth R 3 million each, which are rented out?
The psychology of social comparison makes this inequality nearly impossible to evaluate honestly.
Formula 5: Known competence x focused capital = reduced risk
Buffett only invests in businesses he fully understands. When you multiply in-depth knowledge by concentrated capital, the result is significantly lower risk.
The typical investor replaces the competence factor with hope, hype, or the fear of missing out. Mathematically, anything multiplied by zero equals zero. Understand what you are investing in, including the philosophy of the funds you select and the sectors and prices you are exposed to through Index Funds.
Read: As Warren Buffett prepares to retire … Does his investing philosophy have a future?
Hope is not a strategy, and luck does not favour most. Buffet has stated that investing is not a game where the person with an IQ of 160 beats someone with an IQ of 130. Temperament beats intellect every time.
Formula 6: Buy during fear + sell during greed = buy low, sell high
Outbreaks of fear and greed will always occur within the investment community. The real challenge is to act against the crowd. If your hairdresser and Uber driver start discussing investments, then it’s probably time to sell.
This is the fundamental investing principle that everyone claims to understand, but almost no one actually executes.
Read: The law of averages favours you when investing
The average investor flips this formula on its head. They buy when the market is surging and sell in panic when headlines turn negative. Refer to Formula 3. Compound growth can only occur if you remain invested.
Formula 7: Interest paid on depreciating assets = guaranteed wealth destruction
This formula has no favourable outcome. When you pay interest on something that is decreasing in value, the maths work against you from both angles. The asset value shrinks while the cost of owning it rises. The outcome is negative every time.
The average investor rationalises exceptions to an equation that has none. They normalise car payments, carry credit card balances, and finance lifestyle upgrades they cannot afford with cash. If the asset depreciates and you are paying interest on it, the equation guarantees wealth destruction.
Read: Mistakes the rich just don’t make
The average investor struggles not because the formulas are complex, but because they resist these mathematical principles as they find simplicity unfulfilling. Complexity creates an illusion of sophistication, while genuine wealth-building mathematics is repetitive, dull, and demands decades of patience.
Give it a go! Simplify your investment strategy by applying the KISS principle, and stay invested. Most importantly, don’t scrutinise your investment values every day unless you enjoy sleepless nights.
Have fun and stay invested.
