Warren Buffett: How to Invest Tiny Sums of Money

I think if you're working with a small amount of money, I think you can make very significant sums. But as soon as you start getting the money up into the millions, many millions, the curve on expectable results falls off just dramatically. So, I just came across a long lost clip of Warren Buffett explaining the exact three things he would do to generate 50% annual returns if he was investing with little money. If you want to build real wealth, you need to see this.

There's an old saying that it takes money to make money. This saying may be true, but the amount of money you need to get started generating high returns is not as much as many would believe according to Buffett. Now, let's get into the video.

From my reading, in the years from 1956 through 69, you achieved the best results of your career quantitatively—29% annually against only 7% for the Dow. Your approach then was different than now. You looked for lots of undervalued stocks with less attention to competitive advantage or favorable economics and sold them rather quickly. As your capital base grew, you switched your approach to buying undervalued excellent companies with favorable long-term economics.

My question is, if you were investing a small sum today, which approach would you use?

“Well, I would use the approach that I think I'm using now of trying to search out businesses where I think they're selling at the lowest price relative to the discounted cash they would produce in the future. But if I were working with a small amount of money, the universe would be huge compared to the universe of possible ideas I work with now. You mentioned that 56 to 69 was the best period. Actually, my best period was before that, was from right after I met Ben Graham in 19 early 1951. But from the end of 1950 through the next 10 years, actually returns averaged about 50% a year, and I think they were 37 points better than the Dow per year, something like that. But that I was working with a tiny, tiny, tiny amount of money, and so I would pour through volumes of businesses and I would find one or two that I could put $10,000 into or $115,000 into that were just ridiculously cheap. And obviously, as the money increased, the universe of possible ideas started shrinking dramatically. The times were also better for doing it in that time. But I think that if you're working with a small amount of money, with exactly the same background that Charlie and I have, and same ideas, same whatever ability we have, you know, I think you can make very significant sums. But as soon as you start getting the money up into the millions, many millions, the curve on expectable results falls off just dramatically."

But that's the nature of it. When you get up to things you can put millions of dollars into, you've got a lot of competition looking at that. And they're not looking as I did when I started. When I started, I went through the pages of the manuals, page by page. I mean, I probably went through 20,000 pages in the Moody's industrial, transportation, banks, and finance manuals, and I did it twice. And I actually looked at every business. I didn't look very hard at some. Well, that's not a practical way to invest tens or hundreds of millions of dollars. So, I would say if you're working with a small sum of money that you're really interested in the business and willing to do the work, you will find something. There’s no question about it in my mind. You will find some things that promise very large returns compared to what we will be able to deliver with large sums of money.

There are three important principles you need to understand if you want to follow Buffett's advice on generating high returns with little money. The first principle is to avoid competition. As demonstrated by Warren Buffett's net worth, investing can be extremely lucrative if done well, and as a result, it attracts the best and brightest from all across the globe. Now, this is a good news, bad news sort of situation. The bad news is that the world of investing is filled with tens of thousands of incredibly smart, ambitious individuals. These people went to prestigious schools and have dedicated their lives to the pursuit of making money in the stock market.

This group is willing to work 80 to 100 hour weeks in order to try to find attractive investment opportunities, and this is not a group that most people should try to compete against. So, I'm going to let you in on a secret: the good news is that if you are watching this video and you follow Buffett's advice, you don't need to.

So let me demonstrate what Buffett means when he says to avoid competition by using an analogy from his business partner, the great Charlie Munger. When asked how to get rich, Charlie likes to say that the key to getting rich is to fish where the fish are. You will see what he means and how this applies to investing in just a second.

Picture yourself in a boat all alone in the middle of a small pond. For the sake of this example, let's say there are 1,000 fish swimming around in the water ready to be caught. You are just an amateur fisherman but you're intrigued by an interesting proposal: a magical investing genie promised you $1 million if you were able to catch just 100 fish. You think to yourself, this is going to be extremely easy. There are 1,000 fish ready to be caught, and you are the only one in the pond trying to catch them. It's only a matter of time until you've caught the 100 fish.

Of course, though, there is a big catch to this proposition—no pun intended. Every 5 minutes, a highly skilled fisherman is going to join you out on the pond. He will be competing against you, also trying to catch as many fish as possible. These newly added fishermen are incredibly talented, having spent tens of thousands of hours fishing over their lifetime. They know all the tricks of the trade.

Let's see how things play out for the first 5 minutes of this experiment. You are out alone on the pond; it seems like every single line you put in the water catches you a fish. Five minutes pass, and here comes the first additional person. You get nervous watching how efficient they are, casting multiple lines and quickly catching fish. You have no idea how they're able to do it. You aren't too worried as it's only one other person, and there are plenty of fish to go around. However, five more minutes pass, and another person joins, then another, then one more.

With each additional person, you notice it becomes slightly harder to catch a fish. Before you know it, there is now a decent-sized group of people competing against you for the fish. The time it takes you to catch just one fish greatly increases. Your competition, being highly skilled and experienced, doesn't seem to have that problem. They are still catching fish after fish.

It's now clear to you that they know something you don't. Time passes and an announcement goes off that all the fish have been caught. You look down at your bucket of fish, knowing it's well short of the 100 required to win the $1 million.

While this analogy is about fishing, it's easy to see how it applies to investing. As the amount of highly skilled and motivated competition increases, the ability to find attractive investments decreases. Like Charlie Munger says, if you want to get rich, fish where the fish are. Many times that means avoiding the places that are crowded by smart, talented, and ambitious people.

This leads directly into the second lesson from Warren Buffett on how to invest when you have little money: focus on small companies. In order to understand why Warren Buffett recommends focusing on smaller companies, you need to first understand how the investment industry works. Professional investors typically are paid a percentage of the total amount of money they oversee on behalf of their clients. Put simply, the more money they manage for clients, the more money they make for themselves.

Naturally, this incentivizes professional investors to manage as much money as possible, creating opportunity for those investing small amounts of money. Many large investors cannot invest in a small or medium-sized stock, even if they wanted to. Let's say there is a professional investor managing $10 billion. Just 1% of that $10 billion portfolio works out to a whopping $100 million for a stock with a $500 million market cap. This investor would have to buy literally 20% of all shares outstanding just for the position to make up 1% of their portfolio.

By the time our professional investor here has bought 20% of the entire company, the share price likely will have risen so much the opportunity is no longer attractive. Because of this, many professional investors don't even look at a stock until the company hits a certain size. Put another way, there is less competition when investing in smaller market cap companies.

A young Warren Buffett understood this dynamic and that it created wonderful opportunities for him when he first was getting started. When Warren was investing small sums of money decades ago, he had to spend literally months pouring through financial documents in a dreary, windowless library to find just one potential idea. Thankfully for us, the internet has made the hard work of filtering through thousands of stocks a whole lot easier. All that we have to do is go to a stock screener and select the criteria we are looking for.

Let's put our market cap range between $100 million and $1 billion. For the PE ratio, let's put that at less than 15. Then we can go to the financial section of the screener and put the net profit to greater than zero to filter out all the unprofitable companies. These criteria provide us with a great list of stocks to look into further.

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Now back to the video. The third principle from Warren Buffett on how to invest with little money is to focus on your best ideas. Conventional investing wisdom states that investors should have what is referred to as highly diversified portfolios. In simpler terms, this so-called conventional wisdom recommends people have stock portfolios that consist of dozens, if not hundreds, of stocks. Buffett believes that is an incredibly foolish way of investing if your goal is to generate high returns.

Instead of favoring diversification, Buffett advocates for a concentrated approach where investors focus on a few wonderful businesses they thoroughly understand. He believes that truly great investment opportunities are rare; however, when these opportunities do come along, Buffett says you have to be ready to pounce.

A story from Buffett's college days demonstrates this point. The year was 1950, and Buffett was a student at Columbia University in New York City, studying under his mentor Ben Graham. A young Buffett had just gotten wind that his idol, Ben Graham, owned 50% of a small, obscure insurance company named Geico. Geico was based in Washington, D.C., just a few hour train ride from where Buffett lived in New York.

Interested in the company, Warren Buffett took the train to Washington on a Saturday to learn more about Geico, but found that the office was closed. Fortunately for Buffett, a kind janitor let him in, directing Buffett to the office of the one employee that was working that day. This employee just happened to be a senior executive of Geico. Impressed by Buffett's determination, the employee spent the rest of the day explaining to a young Warren Buffett how the insurance industry worked and what made Geico special.

Buffett understood immediately that Geico was an attractive investment opportunity. He went home and wrote a buy recommendation on the stock, even getting his research featured in a publication called the Commercial and Financial Chronicle. However, when it comes to making money, none of this would have mattered if Buffett wasn't willing to put his money where his mouth was. Following the advice he would go on to give others decades later, Warren Buffett knew the odds were skewed in his favor and decided to act accordingly. He invested $10,000 of his own money into Geico stock, money that he had meticulously saved from his paper route and the various little businesses he had growing up.

While $10,000 is nothing for Warren Buffett now, back then it accounted for roughly two-thirds of his entire net worth. This is what Buffett means when he says to focus on your best ideas. Warren knew that Geico stock was a great opportunity. However, had Buffett followed conventional wisdom, Geico stock would have just been one of the dozens of other stocks in his portfolio. Instead, Buffett ignored the conventional way of thinking and did what made the most sense for him.

This investment turned out great for Warren. He sold his position a year later for a 50% return. The boldness to act aggressively when the odds were stacked in his favor paid off in a major way. As Buffett has been known to say, "I would be a heck of a lot poorer if I followed conventional financial theory when it comes to investing."

So there you have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.