If the devil’s greatest trick was to make the world believe he didn’t exist, then Warren Buffett’s greatest ruse has been to make the world forget he was a hedge fund manager.
I very much admire Warren Buffett, both as a man and an investor, so don’t take my Biblical allusion too seriously.
Nevertheless, it’s remarkable how little credit you’ll find given to the way Buffett’s early partnerships turbo-charged his wealth, sowing the seeds for him to become the world’s intermittently richest man.
Most pundits have preferred to focus on how Warren Buffett got rich investing in Coca-Cola (and you can too!) or else how Buffett is really a businessman disguised as a stock trader, so you shouldn’t bother.
More recently academics have sought to explain away his market-beating achievements as a combination of factor investing and benefiting from cheap leverage.1
But the truth of how Buffett got rich lies somewhere in between.
Stock picking certainly explains why he’s a millionaire. But his early business success in running money for other people is almost certainly why Buffett is a billionaire.
Secret 1: Buffett the City Slicker
From Buffett’s biography to the regular eulogies about his life, the fact that Buffett claimed a huge swathe of his partners’ gains to enrich himself is rarely mentioned.
That’s a bit like dropping the Wright Brothers from the history of flight, or omitting Bilbo Baggins from The Lord of the Rings.
It’s how Buffett’s wealth accumulation first entered the big league.
After a precocious childhood selling newspapers and investing in his first shares when he was 11 – so far, so fitting the legend – Buffett began his professional investing career on Wall Street as an analyst.
Yes, fans of folksy Omaha – Wall Street, the infamous hive of scum and villainy!
Buffett worked for Renaissance man and genius Benjamin Graham
His initial salary was $12,000, which sounds modest but is the equivalent of more than $110,000 in today’s money. Not bad at all for a 24-year old, even by the standards of modern trading floors.
Buffett’s high starting salary is the first aspect of his wealth accumulation that’s rarely dwelt on by stock pickers who dream of becoming a billionaire on £250 a month in an ISA.
On the other hand, the legend reasserts itself with the truth that Buffett did scrimp and save – he reinvested most of what he earned.
According to my thrice-read copy of The Snowball
Buffett grew his wealth by 61% a year since going to college. That $174,000 is equivalent to $1.6 million in 2019 dollars.
Secret 2: Buffett the fund manager
Buffett was a millionaire in today’s terms while still in his mid-twenties, and we certainly shouldn’t downplay this achievement.
But what laid the foundations for him to enter the ranks of the mega-rich were the private investment partnerships that he set up and ran, largely for family and friends, between 1956 and 1969.
The terms of these partnerships varied. For the first partnership, the seven other founding partners put in $105,000.
Buffett put in just $100.
Here’s his recollection of the deal, from The Snowball:
“I got half the upside above a four percent threshold and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited”.
Buffett felt an obligation to pay back losses partly because his early investors were the closest people in his life. His wife’s father was one of them, and his sister another.
The stipulation that would see him out of pocket if his returns fell below 4% is far removed from the typical hedge fund of today.
Many still charge a 2% fee every year, regardless of performance.
And even today’s greediest hedge funds don’t claim “half the upside”. For years the standard deal was 2% annual and a 20% performance fee – and it’s been falling in recent times – as well as some sort of high water mark to theoretically protect investors from volatility that enriches the manager but not the customers.2
Buffett was looking to take 50% of the upside, not 20%!
True, Buffett’s upside came only after the first 4%, whereas most hedge funds today will take, say, 20% of anything they make at all (even interest on cash in the bank).
This is Warren Buffett we’re talking about here, though – and he doesn’t do miserly returns for long.
In 1957, the three partnerships he was operating gained 10%, against a market down 8%.
1958 was even better. Again quoting The Snowball:
The next year the partnerships’ had risen more than 40% in value. Buffett’s fees so far from managing the partnerships, reinvested, came to $83,085. These fees had mushroomed his initial contribution of only $700 – $100 contributed to each of the seven partnerships – into a stake worth 9.5% of the combined value of all the partnerships.
I hope you don’t need to bust out a compound interest calculator to see how well the partnership fee structure was already serving Buffett.
Sure, he needed to succeed with his stock picking to make decent returns for his partners.
The point though is that it was by leveraging other people’s money into those picks that Buffett made himself rich.
If Buffett had merely invested the $700 that he’d put into the partnerships over those first two years instead, then he’d have grown it to merely $1,078.
That’s $82,000 less than the money he made by investing for other people!
Gearing up his great stockpicking
My point is not that Warren Buffett isn’t a great investor – he is.
Nor am I saying he was ripping off his early investors. He made most of them into multi-millionaires, and they probably never realised how much the arrangement protected their downside.
Most people care more about losing money than making it, so I believe the terms weren’t sheer avarice on Buffett’s part.
Nevertheless, it was the fees generated by his investing talent through the partnerships that made Buffett rich, not those pure stock picks themselves. By January 1962, barely five years after he began, Buffett was a millionaire on paper, with his share of the partnerships’ assets valued at $1,025,000.3
The moral? If you want to get as rich as Warren Buffett, you don’t merely need to start early and grow old. Simply investing like Buffett won’t do it, either.
Instead, to get very rich as an investor, you need to invest like Warren Buffett on other people’s behalf, and claim a good portion of the gains for yourself.
Rich folk history
Ironically, Buffett recently won his 10-year bet against hedge funds partly on account of their high fees.
And in recent years he has championed index funds as the best solution for everyday investors like you and me.
Once you know how well he did from high fees himself in his pre-Berkshire Hathaway years, you can’t help thinking there’s an element of ‘poacher turned gamekeeper’ to this.
(Which is certainly no reason to ignore his advice to invest passively. Quite the opposite!)
Some people have saluted how well Berkshire Hathaway has served its shareholders, compared to how most hedge fund managers milk their customers with the 2/20 structure.
The truth is more complicated. Just as Warren Buffett uses folksy analogies to make economic issues more understandable, his most ardent fans – if not the man himself – have also played us like a fiddle when it comes to seeing how he first got rich.
If Buffett was a private investor in his spare time, as per the myth – if he was a successful everyday businessman investing his excess cash, or maybe even a doctor or a teacher – then he’d very likely have become a multi-millionaire.
I doubt we would have heard of him, though.
Update: 7 December 2012
I don’t know if Warren Buffett reads Monevator – I’d be flattered for sure – but he was less coy about his early hedge fund days in publicity for his later book, Tap Dancing to Work
Here he is discussing his old hedge fund with The New York Times:
Until 1969, Mr. Buffett operated a private partnership that was akin in some ways to a modern hedge fund, except the fee structure was decidedly different.
Instead of charging “2 and 20” — a 2 percent management fee and 20 percent of profits — Mr. Buffett’s investors “keep all of the annual gains up to 6 percent; above that level Buffett takes a one-quarter cut,” Ms. Loomis wrote. […]
“If you want to make a lot of money and you own a hedge fund or a private equity fund, there’s nothing like 2 and 20 and a lot of leverage,” he said over a lunch of Cobb salad.
“If I kept my partnership and owned Berkshire through that, I would have made even more money.”
It was managing money for other people that enabled Warren Buffett to get very rich, very young.
And that early fortune gave him the capital he needed to compound to become a billionaire.
- Leverage is basically borrowing to invest. In Buffett’s case he uses the ‘float’ provided by customers of his insurance companies as cheap capital to invest. [↩]
- However one way this high water mark may in reality prove useless is if a manager simply shuts down any funds that are underwater. [↩]
- Around $7.5 million in 2011 money. [↩]
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As ever, connections and the willingness of friends to part with their cash is a great help to one’s success. Also, let us not forget that Buffet’s father was a congressman and this opens many doors, contacts and opportunities. How many people had the resources to move between Omaha and New York so freely? Also Buffett taught a course on stock markets at the college in Omaha when he was 23/24 years old!
Whilst Buffett is painted as awkward and almost as a nerd in his younger days I’m unsure if that stacks up as without charisma and charm he would not have been able to make such contacts and talk himself into such a good position time after time. Sometimes when idolising people and trying to sell them as a role model it helps to make the person sound as “normal” as possible and sound like anyone else could also be like this provided they follow x,y,z rules (buy my work to find out these rules etc.)…
With Buffet I believe this is the case… He had a great hand up in life, great family connections and did not have awful social skins that only reading Dale Carnegie a hundred times could improve.
Also, note that he had such family and friends with a high amount of cash to invest with him in the first place, and willing to do so… Not sure that even some of the great traders of today could get their friends and family to hand over 100K (Let alone adjusting this for inflation, which makes it probably over 1 Million) for a person to invest with!
Iwould run, not walk, to invest in any hedge fund that offered me those terms.
Yes, WB did leverage OPM, but for this guarantee to be credible, and for him to deliver, imply there was something very different about him than your usual hedgie 😉 Too many fund managers seem to run on the premise that the best way to make a million is to start with ten times that much….
@MJ – Yes, there clearly was something to the man even when he was young, which does partly come across in The Snowball. To be fair, it is his friends and family that invest in him, not strangers so much. These were surely the people who knew him best and had seen at first hand what were undoubtedly remarkable mental talents that have been largely obscured by the folksy charm.
@ermine (and @MJ) – Well, who is to say Buffett would have repaid (or been able to repay) those losses after a few down years? I know this is Buffett, and his record and talent were brilliant AND he even closed down his funds after a dozen years or so when he was no longer confident he could deliver outsized returns but… still… there must be some survivorship bias in here.
Thanks for commenting guys!
Nice overview of special considerations that enabled Buffett to get to the top of the heap. I would recommend Snowball to anyone interested in Buffett’s career. I have always admired his discipline in staying away from that which he doesn’t understand and his recognition that some of the most basic, unglamorous businesses are the best investments.
Great read! Warren Buffet is so often portrayed as a down to earth honest capitalist, when in fact he actually had to hustle and make connections. What a thought!
The myth is what will be remembered…How many people actually talk about how rich the Founding Fathers (US here) were and how they were sick of being taxed? No they just discuss how they altruistically decided to stand up for freedom. I think it is human nature.
I believe that we will see a non-authorized tell all about Buffett post mortem
I’m curious what tax rate Buffett paid on the fees he earned as manager of the investment fund? And then what did he pay in taxes on the $83, 085? I have a friend claiming he paid full taxes on his fees and therefore shouldn’t have to pay more than 15% on money made from investing.
I’m a citizen trying to educate myself so that I don’t make such knee-jerk decisions in the voting booth! Any help?
By the way, I’m a firm beliver in Carl Sagans,” You can have your own opinion, but you can’t have your own facts.” Just saying.
@Nancy — I have no idea about Buffett’s tax situation back in the 1960s. The US tax code was likely very different back then, although as a British writer I’m not best-placed to comment. I do know that Buffett and his partner Charlie Munger were heavily investigated by the US authorities (the SEC) in the mid-1970s, and they didn’t find any major issues or complaints. Also, Buffet famously filed his first tax return as a schoolkid… I doubt anyone out of office or show business has had their tax affairs more publicly scrutinized.
That’s not to say he didn’t *legally* use the tax system to minimize taxes. It’s one reason he keeps money rolled up in Berkshire’s investments, for instance, and doesn’t pay a dividend.
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I refuse to pay commisions to hungry, greedy hedgefund managers whom couldnt even guarantee a return….its like shooting craps and paying the table manager regardless of the outcome….I invest in good individual stocks and bonds with better returns and control.
Good article. But it somewhat glibly underestimates the wealth Buffett create after the partnership.
If you are making 30% for your partners year after year, you deserve your 25% profit share. Not many people can claim 30% a year. 15-20% is considered outstanding in this day and age.
Buffett’s greatest wealth was produced in the Berkshire era, through investments like GEICO or The Washington Post. In dollar terms, probably something like Coke is near the top of the list.
Also remember, the path to greatest wealth is having a publicly-traded company where your earnings are given a market multiple. Look at the richest guys and you’ll see they all have successful listed companies.
@Cogitator99 — Thanks for your thoughts. We don’t really disagree — I stand behind nobody in my admiration for Buffett and his stock picking skill. Fact is though, he is not the folksy private investor compounding machine of popular legend. People think if they save hard and pick stocks like Warren Buffett they too can become billionaires. That’s misleading — Buffet was and is a financial insider and professional, albeit of a distinct variety.
We individual stock pickers of comparatively modest means can however become multi-millionaires in the best case scenarios, and I think that’s plenty aspirational. 😉
Very true.
No, I pretty much agree with the points you brought up. I mean, if people think they can become billionaires through pure stockpicking, that’s plenty misguided. Usually there is a vehicle through which alpha-generating ability is magnified, such as a hedge fund or a public company.
As you noted, for Warren this was the partnership early on. Just wanted to point out that Berkshire Hathaway itself served a similar purpose after the early phase; it’s what brought him from hundreds of millions to billions.
Fair point though, that people can get the wrong idea about Buffett. This article certainly helps shed the misconceptions.
Yes I agree, people won’t be billionaires if they save hard and pick stocks like Warren Buffett. But maybe they will become millionaire. And that’s good enough for them. To make more, you need another factor, i.e. high salary, money from business. Put most of your salary regularly into stock until the salary is too small compared to your portfolio. And yes Buffet’s money from the partnership also help a lot at the beginning.
I strongly believe that studying Buffett’s life and principles will make us more adept investors. I obsessively studied his life and investment style for many years and read every book I could lay my hands on in the process. This has made me somewhat of an expert on books written about Warren Buffett and I want to share my knowledge with you. If you are interested, kindly visit my recommendations on http://www.bestbuffettbooks.blogspot.com
In my opinion social intelligence is the edge here and it just proves that morals will not get anyone anywhere but I have to commend how he and the likes of Bill Gates have been able to convince the world the are the ‘do-gooders’. I for one envy those that have mastered this act as we live in a modern world but for me, I am imprisoned by my conscience lol
Another interesting take on this is the following academic paper by three professors at Yale: http://www.econ.yale.edu/~af227/pdf/Buffett's%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf
They point out that most of the performance of Berkshire Hathaway can be explained by just one factor:
Low beta stocks should deliver lower returns than high beta stocks in order to reflect the lower risk, but in practice the return on low beta stocks is not as low as it should be. This anomaly can therefore be exploited by investing in low beta stocks and using gearing to increase the risk to the same level as high beta stocks. The result should be higher returns than if you had bought high beta stocks.
This anomaly survives, because many investors are not allowed to borrow (pension funds, mutual funds) and other investors don’t want to take the risks of borrowing, because if the market takes a downturn and your lenders lose confidence, your business can fail. Apparently, most of the apparent outperformance by Berkshire Hathaway can be explained by its gearing.
What is really smart about Berkshire Hathaway is that a lot of its debt is in the form of insurance float. Insurance companies collect premium income and eventually pay out claims and distribute any surplus income as dividends, but in the meantime they sit on the premium income and can invest it to earn investment income. BH takes this surplus cash from the insurance subsidiaries and uses it to fund the other investments. This is a much cheaper form of funding than paying interest on explicit debt and it is much more stable, because there are no explicit lenders who might decide to withdraw their funding. This puts BH in a position to exploit the anomaly mentioned earlier.
This doesn’t mean Buffett is not a genius; just that his genius was that several decades ago he spotted the opportunity to do this.
@ivanopinion — Yes, it was an interesting paper but I don’t think it goes as far in explaining away Buffett as some read it as going at the time, as I’ve discussed before. I agree with you though that a big part of his genius was spotting the potential.
Buffett wasn’t using the float when he generated the excellent returns for his partners in his hedge fund/s that I discuss above. He is a multi-billionaire because of the float, but he’d be extremely rich and show excellent stock picking skills (/luck, if you’re a EMT diehard! 😉 ) without it, too.
People are forgetting that generating float isn’t exactly easy either. At least not profitable float.
How many people has he put out of work? Will he be able to buy his way into heaven with his investment in the Gates’ foundation?
Hi Jumbybird,
Not sure how many people he’s put out of work, but Via Berkshire he employes about 330,000 people.
As for buying his way into heaven, I dont think he’s worried about that as he’s an avowed atheist.
Not quite sure what makes you so angry at someone that has basically donated most of their working life’s proceeds to charity?
Paul
Amazes me how many people misunderstand the Buffett strategy at Berkshire. You pick a stock and it goes up 5% – but if he invests in the same stock and it goes up 5%, he gets 10-20% return on that. How? It’s a deep value liability funding strategy inasmuch as it is a value investing strategy. Best explanation I’ve read on this is from these guys: https://www.scmessina.com/2015/02/if-warren-buffett-had-to-start-today-could-he-still-reach-his-current-level-of-wealth/
@Stillwater — Yes, the float from the insurance operations has been massively important, though hardly a secret. As your interesting link discusses, both he and Munger have repeatedly pointed to it, plus there was that academic research a couple of years ago explaining all his alpha away via leverage and low volatility (though I think giving insufficient credit to Buffett for actually devising this strategy 50 years in advance of their backtesting).
This article is about his hedge fund days, however, where float wasn’t a factor (although other people’s money certainly was, as I say — the performance fees he earned on his investor’s money! 🙂 )
Who is the UK version of Warren?
Thank you for this great article, i was arguing with a friend of mine (we both work at an investment bank) about how Warren Buffet’s “buy and hold” strategy made him a multi-billionaire, i argued that he was already a millionaire in his 20s there was noway in hell a “buy and hold” strategy would get you rich that quick. I actually didn’t have any facts to back it up it was just my hunch.
After reading your article i’ve proven my hunch right and i’m sending this to my friend :). I just knew it, there’s more to his story about getting rich early by the mythical Buffet “buy and hold” unless u got really lucky buying ultra-high growth penny stocks
Unfortunately alot of people are fooled by the Buffet myth, my clients included that by simply buying value stocks and holding long term they will get rich soon, many are left very dissapointed after they look at their returns.
I understand that early in his career, when Buffet didn’t manage a mountain of wealth, he proved himself a wonderfully astute investor. I also understand that now that BH is such a large company his returns are much less extraordinary.
I have seen suggestions that once he became a Big Man among investors he became astute at pulling strings in Washington to the advantage of BH. As someone above implied, he presumably learnt young about how cheap it is to buy US politicians. WKPD: “In 1942, his father was elected to the first of four terms in the United States Congress, and after moving with his family to Washington, D.C., Warren finished elementary school, attended Alice Deal Junior High School and graduated from Woodrow Wilson High School in 1947”.
I don’t buy the story of folksy Saint Warren, but as Paul implied above you’d need to be a resentful jerk to hate a man who “basically donated most of their working life’s proceeds to charity”. (Though myself I’d have said “his … proceeds”.)
Does Buffetts approach add weight to your earlier article on using a cheap fixed mortgage to provide leverage to invest? I’m not sure Buffett would have used it now but he’d have likely clocked on to it back in 2008!
To me the more interesting character is Charlie Munger, who didn’t have as many connections and also had a family early on but still achieved tremendous success. Some team.
There’s no doubt that WB’s done very well. There’s also no doubt that as the Ivy-league educated son of a US Congressman he had considerable advantages. Normal investors put too much store by what he says.
Good article, I too was sceptical about how the media portray buffets wealth…
I knew it all sounded too easy and good to be true… He even claims his cigar butt approach to investing isnt the right way to go but that’s his best ever returns…If he started again he would definitely go back to this approach…he even admitted this in India.
I also realised he got a 6 figure salary (in today’s money ) at 24… Again something most people just won’t get – the idea that he was some non confident awkward person just doesn’t add up to the reality of what happened such as getting someone to provide such a large salary as your first main job.
Having said this, if his advice can make you a multimillionaire but just not a Billionaire then I think I can live with that 🙂
For someone as bright as buffet I am surprised that’s what he is doing with his wealth when charity really has proven to be a waste to third world countries in the main
I like coming back to this. I used to admire buffett a lot years ago but increasingly the fake news on him and frankly his political views make me far less impressed now I am older.
His basic advise is fine but hardly revolutionary for normal people. The comment on his starting salary is also a great point.. What 24 year old grabs a gig ovr 120k a year? Only just over 300k people earn 160k now and how many of those are 24..
I’ve heard him talk badly about leverage and that if your your smart you don’t need it, this is just a lie as proven by what you have shown above.
I bet if he was a republican he would not have this reputation.. The cynic in me suggests he plays the part of a democrat to improve his image