Over the course of many decades, legendary investor Warren Buffett has gone from a schoolboy buying shares with his paper round earnings to a multibillionaire.
There has been a variety of reasons for his success, from his skill at capital allocation to a keen eye for managing risk.
But one of the key reasons Buffett has been able to grow rich from his stock market investments is because he has reinvested the money earned into buying more investments.
That is known as compounding. Not only has it worked well for Buffett, but it could help me build wealth as a small private investor too.
Compounding dividends
As an example, take one of the shares owned by Buffett’s company Berkshire Hathaway. This is Diageo is the London-based alcoholic drinks firm that offers a dividend yield of 2.5%.
It has consistently raised its dividend annually for over 30 years, underlining the sort of financial rewards that can come from Buffett’s approach of buying shares in high-quality businesses that can grow their profits, thanks to some competitive advantage.
If I invested £1,000 in Diageo today and simply reinvested the dividends I received into more Diageo shares, then after 29 years I would own £2,000 worth of its shares. And that’s without having put in a single penny more.
With a higher-yielding share, the effects could be even more dramatic. Take my stake in M&G, which has an impressive 10.3% yield. Compounding the dividends on that would mean I could double my money in under a decade.
These examples presume flat share prices and dividends. Of course, dividends are never guaranteed, but I think the point is still clear. Compounding can be a dramatic way to build wealth over the long term.
Capital gains
But a lot of Buffett’s compounding has not involved dividends.
Instead, he has chosen to keep money in businesses he rates highly for decades. If they have a strong business, he figures that they ought to be able to generate profits they can then plough back into the business to make even more money in future.
That might not seem as obvious an approach as compounding dividends. But it can be very powerful. Buffett bought his stake in Apple under a decade ago. Yet it is now worth over five times what he paid for it, even excluding the dividends he has received along the way.
Investing like Buffett
By following this simple approach of using my earnings from investments to buy more shares, I hope I can accelerate the long-term process of building wealth.
That could involve a combination of compounding dividends and putting any capital gains I earn in my Stocks and Shares ISA back into buying more shares.
