Warren Buffett believes this one investing rule is key to his success

In this article, I’ll use my position in a UK-listed ETF to help illustrate a well-known ‘investing trick’ that’s favoured by the likes of Warren Buffett!

| More on:
Fans of Warren Buffett taking his photo

Image source: The Motley Fool

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Warren Buffett has earned the nickname ‘the Oracle of Omaha’ due to his place of birth (Omaha) and his apparent ability to foresee the future. His amazing propensity to know which stocks to invest in seems prophetic to many people. 

Of course, there is no real magic involved. 

As Buffett admits himself, his success is largely due to something we all have the ability to harness: compound returns.

The snowball effect

Buffett describes the power of compound returns as similar to that of a snowball: as it rolls downhill, it grows exponentially larger and larger.

In investing, this is exhibited by an increasing degree of growth over time.

The exponential growth of compounding returns

Created on thecalculatorsite.com

Let’s use the iShares Core S&P 500 ETF (LSE:IUSA) as an example. This UK-listed exchange-traded fund (ETF) provides exposure to major US companies listed on the S&P 500, such as Microsoft, Apple, Amazon, and Buffett’s own Berkshire Hathaway.

The ETF is weighted towards tech stocks (30%) but also includes exposure to sectors such as financials, health care, industrials, and energy.

Over the past 10 years, the ETF provided annualised returns of approximately 12% per year. It’s worth noting that it made losses in 2018 and 2022, by -4.7% and -18.4%. It has an average price-to-earnings (P/E) ratio of 25.5 but the price-to-book (P/B) ratio of 4.44 is quite high, suggesting the shares could be overvalued.

So, based on an average 12% rate of return, if I invested £100 in the iShares Core S&P 500 ETF, I could have £112 after the first year. Does that mean after the second year I’ll have £124? And after the third, £136? 

No.

The magic of compounding returns means my total return grow even more because the initial investment now includes the accumulated returns. So after year one, I would have £112, but in year two, with £112, the returns would be £13.44, bringing my total to £125.44. In year three, the returns would be £15.05, bringing my total to £140.49.

Created on thecalculatorsite.com

Of course, this is just a simple example — in reality, these numbers would differ slightly due to price fluctuations throughout the year.

Time in the market

The magic of compounding returns is echoed in the popular saying ‘It’s not about timing the market, but about time in the market’.

Timing the market refers to the act of trying to buy and sell at opportune moments. This is opposed to ‘time in the market’, meaning being invested for a long period. Buying and selling frequently can be profitable for some but statistics show that usually it’s less profitable than simply staying invested for long periods.

Of course, it’s not all down to compounding returns. Experienced investors like Warren Buffett have a deep understanding of global markets and spend hours researching potential stock options.

For us lesser experienced investors, investments like the iShares Core S&P 500 ETF provide exposure to a well managed and diverse portfolio of stocks. I see it as a low-risk option that I hope will provide me with consistent and reliable returns for years to come.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Mark Hartley has positions in Apple, Microsoft, and iShares Public - iShares S&P 500 Ucits ETF. The Motley Fool UK has recommended Amazon, Apple, and Microsoft. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Young Caucasian woman holding up four fingers
Investing Articles

7%+ dividend yields! 4 FTSE 100 shares for investors to consider buying in April

These FTSE shares offer dividend yields comfortably above the index average of 3.7%. Here's why they could be good passive…

Read more »

Dividend Shares

£10k in an ISA? Here’s how to generate a ton of passive income

Passive income can provide a lot more financial freedom and security. Here’s an easy way to generate some within an…

Read more »

Investing Articles

The Aviva dividend yield’s already over 7%. Could it go higher?

Christopher Ruane explains why he thinks the Aviva dividend could be on course to grow this year and beyond. Might…

Read more »

BUY AND HOLD spelled in letters on top of a pile of books. Alongside is a piggy bank in glasses. Buy and hold is a popular long term stock and shares strategy.
Investing Articles

2 shares I’d buy to try and double my money in 10 years

Stephen Wright thinks there are still opportunities to to buy UK shares that can double in value over the next…

Read more »

Three signposts pointing in different directions, with 'Buy' 'Sell' and 'Hold' on
Investing Articles

NIO stock has crashed! Here’s why I still wouldn’t touch it with a bargepole

I've been watching NIO stock falling heavily, and wondering when might be a good time to get in cheaply. Here's…

Read more »

Investing Articles

Why have Rolls-Royce shares fallen this week?

Rolls-Royce shares remain the best performing on the FTSE 100 over the past year, but there's been some pullback. Dr…

Read more »

Investing Articles

With a 4.3% yield, I consider this FTSE company an exceptional investment

Oliver Rodzianko say this FTSE company is focused on quality and long-term survival. As such, he thinks he'll hold it…

Read more »

Investing Articles

How I’d invest £10,000 in a Stocks & Shares ISA and aim for a £45,500 second income

Millions of us aren’t earning the second income we deserve. Here, Dr James Fox explains how he’d get his savings…

Read more »