I recently finished reading a collection of Warren Buffett’s annual letters to Berkshire Hathaway shareholders, and I wanted to share some of Buffett’s simple but powerful insights with you.
Investing is often viewed as giving up money now in hopes of getting back more money in the future. Buffett’s definition is more specific and demanding: The transfer of purchasing power to others now with a reasonable expectation of receiving more purchasing power in the future, after taxes. While these definitions may sound similar, the inclusion of taxes and purchasing power effects has important implications for investors. In considering how best to overcome the impact of taxes and inflation and to build wealth, Buffett divides the investment world into three categories: currency-based assets, assets that produce nothing but have value, and productive assets.
Currency-based assets include money market funds, CD’s, bonds and bank deposits. This category is sometimes viewed as safe, because the assets often resemble cash, and prices tend to be stable. Historically, returns on these “safe” investments have struggled to outdistance the effects of inflation and taxes. In my lifetime (I was born in 1964), the purchasing power of the U.S. dollar has declined by more than 86%. Just to keep up with inflation, investors needed to earn more than 4% a year. Add a 25% tax rate and investors required about 5.5% to generate even a minimal increase in purchasing power. T oday, low rates on currency-based assets nearly guarantee a loss of after-tax purchasing power, and investors could fare far worse should inflation rise to historically normal levels.
Assets that produce nothing but have value may seem a contradiction, but they are sometimes quite popular. Investors essentially buy them in hopes that others will pay a higher price. Gold is currently the most popular investment in this category. And while gold has done a fairly good job of simply keeping up with inflation over very long periods of time (think 50 years or so), many investments in this category (like most collectibles, art or antiques) have fared far worse. While it’s possible for these assets to rise in price as the pool of buyers grows, historically they’ve done a poor job of building real wealth. Why? Because an ounce of gold will never grow to two ounces, nor will it produce anything until it is exchanged for something else.
Productive assets on the other hand, such as a profitable business or income-producing real estate, have the ability to generate recurring amounts of cash. Managers of these assets can increase asset values by using this recurring cash to invest greater amounts of capital into the business or to acquire other productive assets. Investors can do the same through the use of their dividends. Either way, the net effect is that productive assets can compound their cash flows over time. These qualities have made productive assets far and away the best assets for investors to use to outdistance the effects of inflation and taxes and build real wealth.
Since the goal of most investors is to increase after-tax purchasing power and build real wealth, it’s easy to see why Buffett’s most recent letter urges investors to focus not on short-term price changes, but “…on the future productivity of the asset you are considering.”