Nestled away on page 204 of Alice Schroeder’s excellent biography of Warren Buffett is the following passage: “[Buffett] had chosen an inviting gray two-story Tudor with picturesque half-beams, a big stone chimney, and a cathedral ceiling. Even the decision to rent a home had been unconventional; owning a home was the quintessence of what most young Americans aspired to in the mid-1950s. The hopelessness of the Depression and the dreary wartime days of making do were fading into memory. Americans stocked their new houses with all the exciting new features and appliances that were suddenly available: washer-dryers, freezers, dishwashers, electric mixers. The Buffetts had plenty of money to buy all these things. But Warren had other plans for his capital, so they rented. And the house they were renting, while attractive, was just barely big enough for them. Howie at two would have to sleep in a largish closet.”
The behaviors associated with generous consumption that receive significant media attention can be consistent with building rapid wealth once you have a substantial capital base, but are far more detrimental when you are trying to build up that initial capital base.
If a couple has a $10,000,000 portfolio that consists of private businesses, common stocks, corporate bonds, real estate, and government bonds, this person could be generating $500,000 in annual income from a portfolio that grows on average at 6.5% without any additional reinvestment. This person could appear to be living large–spending $33,333 per month or $400,000 per year–and still be getting richer by having $100,000 to passively reinvest into new investments that can grow at 6.5% while also having the remaining $10,000,000 base to grow at 6.5%.
The appearance of excessive consumption can still accompany rapid wealth-building if the portfolio size is substantial enough (this is the real danger of the keep up with the Jones mentality–everyone has different asset bases–so you are either trying to keep up with someone who is spending a lower percentage of assets than you are and thus you are needlessly harming yourself, or you are taking financial cues from someone that is doing a poor job of managing an estate if the consumption consumes a large portion of their asset base).
Part of the reason why Warren Buffett has been able to amass such substantial wealth is because his tastes have been modest relative to the earnings potential of what he could spend. He often says that he has been blessed with few material desires in life, and he has everything he needs that makes him happy. That is most likely an accurate statement–Buffett hasn’t hesitated to purchase a Laguna Beach second home, significantly renovate his property, or use a corporate jet (and the latter has been funded through Berkshire).
But if you study Buffett’s behavior in his late 20s–a time at which he already entered the Omaha 1% but was still far off the national 0.1%–his spending habits weren’t just modest compared to his cash-generating power. It was more than that–there was some self-deprival of basic goods and services so that his money could compound. He benefitted enormously from having a spouse that supported such a delayed gratification strategy, as he mentioned that if he married Nebraska’s 1949 beauty pageant winner Vanita Mae Brown, he would have never become an accomplished businessman of note because she would “spend a buck twenty five” for every additional dollar of wealth he would create.
It’s rarely discussed, but living well below his means was an important aspect of what drove Warren Buffett to substantial riches so quickly. Some people think that successful individuals are immune from this. But they’re not–the rapid consumption you see is the result of people spending from an already substantial base–but keeping expenses unusually low when trying to build that base is a necessary condition for seeing rapid increases in net worth.
There are three ways to view spending:
The first is the superficial way when you only compare initial costs. If something costs less upfront, or has lower monthly payments or whatever, it is preferred. The tendency to think this way is generally exploited by creditors that lend to consumers and arrange for low monthly payments but long debt payment terms.
The second way to view spending mirrors that of an engineer-you calculate life cycle costs and begin to understand that a chair that lasts ten years and sells for $100 is cheaper than a chair that sells for $80 but only lasts three years.
The third way, and I think this is what Warren Buffett did early in his life, adds an additional metric. Not only does he measure the true cost of something over a lifecycle, but he also combines that calculation with his own expected financial capabilities over the same time period. Instead of merely measuring which item is cheaper on a relative basis, he includes the additional step of measuring opportunities relatively and then relating that back to his own changes in projected income. This is why he made the sometimes counterintuitive decisions of choosing items that were more expensive over the life cycle but required less cash upfront (basically, he knew that his 20% compounding of funds would smash the opportunity cost associated with choosing spending options that were relatively cheaper upfront but would cost more over the long haul).
The fact that he lived in Omaha, and lived in low-cost housing with a roommate when he was in New York, played a facilitative role in his wealth-building. Again, this was all counterintuitive–the assumption that existed then, and even exists now, is that you must be in New York to make a successful career out of market-based investments.
When people study Warren Buffett, they often focus on the specific investment (and the common stock ones at that). Yes, that is important. But his success consists of a triumvirate of factors–he made successful investments, he used optimal tax strategy and legal structure to earn excess returns from those investments, and he created a sizable gap between his own spending and what he was earning. If you’re interested in the rarely reported low spending aspect of Buffett’s personality, you should read Chapter 20 “Hidden Splendor” of Schroeder’s book Snowball.
Originally posted 2016-01-24 15:41:58.