The simple strategy driving Warren Buffett’s 20% annualised gains from stocks

Over the past 56 years, billionaire investor Warren Buffett has achieved compounded annual investment gains of just over 20% a year.

We know this because he set out the performance figures in his annual letter to the shareholders of Berkshire Hathaway. And it’s via that company set-up that he invests in entire businesses and the shares of stock market companies.

That doesn’t mean he actually achieves that 20% return every year. It’s an annualised figure. And in reality, Buffett has experienced volatility along the way. For example, in 2021, his return was just over 29%. But in 2008, Berkshire Hathaway posted an almost 32% decline in its per-share market value. And back in 1998, the gain was a little over 52%.

Buffett harnessed the power of compounding

But averaging 20% a year for almost six decades is no small achievement. However, at first glance, the figure might not look that high. After all, some stocks make gains of 100%, 1,000%, and even 10,000% or more over just a few short years. So how impressive can 20% a year really be? 

And to answer that question I’d point to the consistency of the outcome. The ‘magic’ happens when we compound such gains over a long period of time. And compounding average annual gains of 20% for more than 50 years can lead to life-transforming financial outcomes.

For example, if we invest £1,000 and compound annual gains of 20% for 10 years, we’d end up with a portfolio worth just over £6,000. But if we compound for 20 years, the value shoots up to more than £38,000. And compounding 20% for 40 years causes the figure to shoot up to almost £1.5m.

Indeed, it’s clear to see how Buffett’s focus on compounding gains has propelled him into the multi-billionaire club over time.

Charlie Munger reveals the strategy

I watched an interesting video recently featuring Charlie Munger. He’s Berkshire Hathaway’s vice-chairman and right-hand man to Buffett. Munger explained the simple strategy that both men use to select investments for Berkshire Hathaway.

First, they only deal in things they’re capable of understanding. Second, they search for businesses possessing characteristics giving them a durable competitive advantage. And third, they look for a management team in place with a lot of integrity and talent.

Fourth, Munger said no matter how wonderful a business is, it’s not worth an infinite price: “We have to have a price that makes sense and gives a margin of safety considering the natural vicissitudes of life.”

Munger then went on to say “it’s a very simple set of ideas.” And he reckons the reason those ideas haven’t spread faster is they are too simple.

Indeed, it’s easy to stray into the territory of making things complicated in all areas of life. But Munger’s and Buffett’s simple strategy for investing has clearly worked well for them.

However, it’s worth remembering that although their strategy is simple, it may not prove to be easy to replicate in practice. All shares carry risks as well as positive potential, even when selected using this simple strategy.