Berkshire’s annual reports and letters to shareholders were just out end of last week. As every year, Mr. Warren E. Buffett writes in a very engaging and straight-forward style about his successes, his failures, and his general observations on the markets. His letters became a kind of American Sakura (Cherry Blossom in Japan).
But my posting today is not about this 2007 Berkshire letter. While following links about Berkshire’s letters, I came across this very interesting blog: Reflections on Value Investing. One of their posting referred to a letter written on January 18, 1963, in which Mr. Buffett discussed The Joys of Compounding:
I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30, 000 invested at 4% compounded annually would have amounted to something like $2,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962 Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.
The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.
5% / 10% / 15%
10 years: $162,889 / $259,374 / $404,553
20 years: 265,328 / 672,748 / 1,636,640
30 years: 432,191 / 1,744,930 / 6,621,140
Mr. Buffett’s letter a year later, 1964, again discussed The Joys of Compounding, with the following example:
Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchre d into such an obviously low-compound situation as the discovery of a new hemisphere.
Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo de Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to about $20,000.
If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6% I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment.
However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.
Below are shown the gains from $100, 000 compounded at various rates:
4% / 8 % / 12% / 16%
10 Years: $ 48,024 / $115,892 / $210,584 / $341,143
20 years: 119,111 / 366,094 / 864,627 / 1,846,060
30 years: 224,337 / 906,260 / 2,895,970 / 8,484,940
And finally, Mr. Buffett explained to his partners:
Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.
Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.
One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this) to obtain the last laugh on Minuit. At 6 1 /2%, $24 becomes $42,105,772, 800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.
It striked me as the best compounding definition I came across; hence I wanted to share this here. If you found it half as interesting as I do, I highly recommend you read The Berkshire Hathaway shareholder letters, or browse through this very interesting blog, which highlight the books recommended by Warren Buffett.