Buffett settles for 90-cent dollar bills – shouldn’t you?

Author: Rocco Huang

Covestor model: Tortoise and the Hare

Value investing is frequently described as “buying dollar bills for 50 cents.” If I tell you that we are better off searching for dollar bills for 90 cents, you may laugh at my lack of ambitiousness: “Why should we settle for less?”

Several weeks ago, Mr. Warren Buffett  told the audience at Fortune magazine’s Most Powerful Women conference in Laguna Niguel, CA: “If I can buy dollar bills for 90 cents, I’ll buy them.”

Apparently Mr. Buffett is not very ambitious, either.

Let me explain why it is more realistic to search for dollar bills on sale for 90 cents. In practice, no one in human history has managed to consistently “buy dollar bills for 50 cents.” The expression should not be taken literally, and should be understood in the same way we say “my two cents”, “million dollar question”, etc.

Let’s image what would have happened if someone indeed has managed to consistently buy stocks at 50% discount. Assume that this person finds such an opportunity every three years. Then he will be able to outperform the market by about 26% a year. (For the geeks: (100/50)^(1/3)-1= 26% )

If someone is able to beat the market by 26% a year, and that the market returns about 10% a year, then he is getting a return of 36% a year. Even the greatest investor in the world, Warren Buffett, hasn’t been able to achieve that over a long period of time.

On first thought, 36% may not sound much to you. There are plenty of small investors who manage to return 36% a year, at some point in time. But none can achieve it consistently.

If one started with $50,000 of initial capital 50 years ago, and managed to find a “dollar bills for 50 cents” opportunity every three years, and returns 36% a year, he should have a personal wealth of $238 billion today. The third wealthiest person on this planet, Mr. Warren Buffett, has a net worth of less than $50 billion, and in 1961 he certainly had more than $50,000 to start with. I will take the lack of a quarter-trillionaire stock market investor as the best proof that no one has managed to pull off the proverbial “buying dollar bills for 50 cents” feat.

Buying dollar bills for anywhere less than a buck is easier said than done. Buffett’s Charlie Munger agreed: “[Value Investing is] not supposed to be easy. Anyone who finds it easy is stupid.”

Now let’s be a little bit more modest. What if we are looking to buy dollar bills for 90 cents. Let’s say we find one such opportunity every 2 years. Then you can outperform the market by 5.4% a year (For the geeks: (100/90)^(1/2)-1=5.4%). Adding a normal market return of 10% a year, you are getting a annual return of 15.4%.

Go back to the same $50,000 starting capital example. If you start with $50,000 in 1961 and return 15.4% a year, then you should have more than $64 million in the bank today.

I don’t know about you, but I can comfortably live with that outcome if I am actually fortunate enough to have that outcome. Mr. Buffett clearly can live with that too.

50-cent dollar bills are rare. Most of the time, dollar bills seemingly on sale for 50 cents are just traps or highly risky gambles. If something is too good to be true, it is not true. Warren Buffett has advice for us on risk-taking: “You only have to get rich once.” My interpretation: if you grow $50,000 to $64 million by the time you retire, you are rich, period.

If you grow $50,000 to $1 billion at some point in your life, lose it all, then make $1 billion again, and finally lose it all again by the time you retire, you’ve gotten rich twice in your lifetime, but remain poor.

Our chance of getting rich more than once in our life time is higher if we pursue dollar bills on sale for 50 cents. Most of us, though, just want to get rich once.