Warren Buffett's 5 Rules for Money

So if you clicked on this video, it's fair to say that you want to learn how to build wealth and not be broke. Thankfully for us, billionaire investor Warren Buffett has provided us with five key principles that will help you start building wealth and avoid being poor. These principles are incredibly tangible, meaning you can start applying them as soon as this video is over. So make sure to stick around to the end of this video because this advice from Warren Buffett will truly change your life for the better.

Rule number one for Warren Buffett is to live below your means. Buffett is known for being extremely frugal, despite having a net worth of over a hundred billion dollars. Warren is still, let's just call it thrifty. He lives in the same house that he has lived in for 50 years in a middle-class neighborhood in Omaha, Nebraska, and his idea of a fancy dinner is dining at the local steakhouse. His go-to order is $48, according to the online menu—far from luxury dining. Buffett's car resembles something a retired school teacher would drive rather than one of the richest people on the planet. Nice wheels, yeah? Well, so how old is this caddy? I think it's about five years or so. You think the third richest man in the world might have his own chauffeur? But not Warren Buffett; he prefers being in the driver's seat.

As cliché as it sounds, Buffett understands that material possessions can't buy happiness. Instead, he values the independence and freedom that being wealthy provides him and his family. Even as Buffett's income has increased throughout the years, he still lives below his means. Being able to live below your means is a wealth-building superpower. Let me explain what I mean.

So, let's say we have two people, John and Michael. John and Michael are pretty much the exact same; they both went to a good college and got very solid jobs out of college. Let's say they both make $75,000 a year right out of college, and they both work really hard at their jobs and are able to get annual raises that average five percent a year. There is, however, one big difference between John and Michael. John commits to living comfortably below his means. Michael, on the other hand, spends the majority of the money he earns and only saves a relatively small amount of money compared to his income.

Michael earned seventy-five thousand dollars in year one, but his total expenses are seventy-two thousand dollars, meaning he only saved three thousand dollars in year one. Michael's income increases by five percent each year; however, his annual expenses are also increasing at that same five percent rate. Michael is suffering from something called lifestyle inflation. This is where, as someone's income increases, so do their living expenses. They get a nicer apartment, a luxury car, and start going on fancy vacations.

There's a saying that people who live far below their means enjoy freedom that people busy upgrading their lifestyles cannot fathom. You're about to see that saying play out with Michael and John. At the end of Michael's 40-year career, he is able to save $362,000. While this might seem like a lot, keep in mind four years from now, $362,000 isn't going to be nearly as much money as it is today due to inflation.

Take a look at this chart: the blue line is Michael's income, and the orange line is his expenses, and the gray line at the bottom is how much he is able to save each year. Notice how Michael's income increases each and every year; the problem is that his living expenses are also increasing just as much. This is preventing him from being able to save more money and make progress toward building wealth.

Let's see the difference with John. John is committed to living comfortably below his means. John also makes $75K a year but decides to only live on $50,000 a year. John gets an annual raise of 5% each year; however, John is able to resist lifestyle inflation. His annual living expenses only increased by two percent each year. Let's see how different things turn out for John. At the end of 40 years, John has saved a whopping six million dollars. At the end of his career, despite making the exact same income as Michael, John was able to save nearly 17 times more money purely because John committed to living below his means and fighting lifestyle inflation.

Take a look at John's chart; notice how the orange line, his expenses, remain relatively stable throughout his career. This causes the gray line, how much John saves each year, to increase dramatically. This is why being able to live below your means is such an important factor in building wealth. This is the perfect example of the quote: people who live far below their means enjoy freedom that people busy upgrading their lifestyles can't fathom. John has way more freedom and independence than Michael. John could retire early if he wanted to; Michael needs his job to support his lifestyle. This is something Warren Buffett understood at an early age and why he lived so frugally.

A little known fact is that Warren Buffett was able to retire from working for someone else when he was only in his mid-20s. His frugal lifestyle made it so that he could take the risk of starting his own hedge fund at just 26 years old. And who knows? If Buffett didn't have the financial independence that his frugal lifestyle allowed, he likely wouldn't be the legend he is today.

So, this leads perfectly into number two on our list: get to your first one hundred thousand dollars saved and invested as quickly as possible. Let's listen to what Warren's business partner Charlie Munger had to say on the topic.

"Yeah, the hard part of the process for most people is the first hundred thousand dollars. If you have a standing start at zero, getting together a hundred thousand dollars is a long struggle. And for most people, I would argue that the people who get there relatively quickly are helped if they're passionate about being rational, very eager, and opportunistic, and steadily underspend their income grossly. I think those three factors are very helpful."

Once you hit the $100,000 mark, your money starts to work for you, as opposed to you having to work for your money. Here's what I mean: let's say you have a hundred thousand dollars sitting in your investment account. It's a good year for the stock market, and your portfolio generates a 10% return. That is ten thousand dollars in investment income—your money produced for you. The median household income in America is roughly sixty thousand dollars; that works out to about five thousand a month. That means it would take the median American household working for two months to generate the ten thousand dollars in income that your one hundred thousand dollar investment portfolio generated for you.

This is what I mean when I say your money is working for you, as opposed to you working for your money. The other big advantage of hitting this one hundred thousand dollar milestone as quickly as possible is that you give your money more time to work for you. Let's say someone wants to retire at 60 years old. If they are able to hit the $100,000 mark at forty, that money can grow for them for 20 years, assuming a 10% annual return. That one hundred thousand dollars will go to six hundred and seventy-three thousand—not bad at all, especially considering you didn't invest another dollar after you hit that one hundred thousand dollar mark.

However, if this person hits the $100,000 milestone at 30 years old, that portfolio now can grow over a 30-year period, as opposed to the 20-year period before. That extra 10 years makes a huge difference. Instead of having $673,000, this person now has $1.75 million. Now you understand why hitting this $100,000 mark as quickly as possible is so important.

Ignoring Warren Buffett's next piece of advice on the list will prevent you from getting to that $100,000 mark. Number three is to avoid credit cards. Here's what Warren had to say when he was asked what the best financial advice he could give to someone was:

"I think people should avoid using credit cards as a, you know, as a piggy bank to be raided. I had a woman come to see me here not long ago, and she'd come on some money, and not very much, but it was a lot to her. And she's a friend of mine. And she said, 'What should I do with it, you know?' And I said, 'Well, put it on your credit card.' And she said, 'Well, I owe X.' And I said, 'Well, what you should do—I don't know what interest rate she was paying, but I think, you know, maybe I think I asked her and she knew and she was something like 18 or something.' I said, 'I don't know how to make 18, you know? I mean, if I owed any money at 18, the first thing I'd do with any money I had would be to pay it off. It's going to be way better than any investment idea I've got.'"

Having credit card debt is having the power of compound interest work against you. Let's say someone has twenty thousand dollars in credit card debt, and the interest rate on that debt is 20%. That means this person will have four thousand dollars in interest that they have to pay just to prevent the debt from growing. If this person doesn't pay that, four thousand dollars gets added to the twenty thousand they already owe. Now, they owe twenty-four thousand dollars. Twenty percent of that is four thousand eight hundred dollars. If the person still doesn't pay that, 4,800 gets added to the twenty-four thousand dollars. Now that person owes twenty-eight thousand eight hundred dollars. This is compound interest working against you, not for you.

Compound interest is extremely powerful, and you want to make sure it's on your side over the long term. The U.S. stock market has an average annual return of somewhere in the range of seven to ten percent. The average credit card has an interest rate of around 20%. This means that whenever someone pays down their credit card debt, they are generating a 20% return on that money. This is why Buffett said it's such a smart financial decision to avoid credit card debt. It is virtually impossible to become wealthy when you are borrowing money at a 20% interest rate. Maintaining a credit card balance is one of the surest ways to keep you poor.

Number four on the list is only invest in things that you understand. Warren Buffett refers to this as a circle of competence. "That is the key; it's defining what I call your circle of competence, and everybody's got a different circle of competence. The important thing is not how big the circle is; the important thing is staying inside the circle, and if that circle has only got 30 companies in it out of thousands on the big board, as long as you know which sturdy they are, you're okay. And you should know those businesses well enough so that you don't need to read, do lots of work."

A circle of competence is an area of the world where you have useful knowledge that gives you an edge. Each of us, through experience or study, has built up useful knowledge in certain areas of the world. Some areas are understood by most of us, while some areas require a lot of specialization to evaluate. Buffett's business partner Charlie Munger summed it up perfectly. Here's what he had to say:

"I look for things where I have an advantage over other people. I don't play in a game where the other people are wise and I'm stupid. I look for a place where I'm wise and they're stupid. You have to know the edge of your own competency. The quickest way to lose money is to invest in things you don't understand."

We saw a lot of that over the past couple of years. People were investing in things they had no idea about simply because they thought it was easy money. They saw other people seemingly making money, and they wanted in on the action. There's this misconception out there that in order to get rich, your circle of competence has to be extremely wide, that you have to be an expert on everything. Now Buffett would disagree with this notion. He frequently tells the story of Mrs. B, the founder of Nebraska Furniture Mart, one of the companies Berkshire Hathaway owns.

Now, Mrs. B was born in Belarus and came to America when she was 20 years old, not even knowing how to speak English. It wasn't until she was 40 years old when she opened the Nebraska Furniture Mart in the basement of her husband's store. The business became successful because Mrs. B understood two things very well: how to buy furniture at a discount and how to keep expenses low at her business. She didn't understand accounting, finance, how to invest, technology, or much of anything else. Her circle of competence was extremely narrow. However, that didn't stop her from becoming incredibly wealthy. She sold her business to Buffett for over 100 million dollars in today's money.

Most rich people seem to have an extremely narrow circle of competence. They are experts in one area, and they stick to that area. This is true whether you're talking about the richest people in the world or the richest people just in the town you live in. One of the wealthiest families in my hometown owns the local trash collection company. The trash collection business is right in the middle of the owner's circle of competence. He's not trying to go out and open a coffee shop or an e-commerce store; he sticks to what he's great at, and it pays very well.

How exactly do you develop a circle of competence, though? Well, that brings us to number five on our list: be a learning machine. It's a commonly talked about fact that Warren Buffett reads six hours a day. While you don't have to be that extreme by any means, a big reason why Warren has been so successful is because he's a so-called learning machine.

"Yeah, well, of course, I've watched Warren all these decades, and he's learned a hell of a lot even the last 20 or 30 years. Those basic principles alone that he knew a long time ago wouldn't have given him the ability to make the recent investment decisions as well as he's made them. It's a lifelong game, and if you don't keep learning, other people will pass you by."

The knowledge and skill sets that helped Warren Buffett in his first taste of success is what caused him to become the greatest investor of all time. It was the fact that Warren was obsessed with bettering himself and improving his skills that made him one of the richest people in the world. When Buffett had his start, he was making money buying failing businesses that were selling for less than the value of everything the company owned. He would buy a business for ten million dollars that had thirty million dollars worth of cash, equipment, and real estate. Because these companies were usually tiny by today's standards, that approach could only take Buffett so far. So he had to change his approach.

Through continuously learning, Buffett eventually shifted his approach. He went from buying failing businesses that were incredibly cheap to buying great businesses that were selling for a fair price. Thirty-year-old Warren could have never imagined that his largest investment ever would be a technology company like Apple. However, Apple has been Buffett's most successful investment ever, with a profit of over a hundred billion dollars so far.

The Warren Buffett that we know and love today wouldn't exist had he not been a learning machine. This advice still applies to you, even if you aren't a billionaire like Warren Buffett.

Meet Sam. Sam works in sales. Because he works in sales, his income is directly correlated to how much of his company's products he's able to sell to customers. Sam starts out as an average salesperson, meaning his income is also pretty average. However, let's say Sam watched this investor center video on Warren Buffett, and he saw the importance of being a learning machine.

Sam then decides to focus on improving his skill set when it comes to sales. Each year, Sam gets a little bit better. As he improves his skill set, he is able to sell more and more, and his income increases each year. Sam gets better and better until one day he is the top-performing salesperson in his office. Sam is making more money than he knows what to do with. While this is only an example, it demonstrates the importance of continuously learning and upgrading your skill set. The more you learn, the more you earn. This concept applies whether you're a salesperson, a plumber, a barber, a waiter, or an investor.

So there you have it. If you made it this far in the video, make sure to like this video and subscribe to the channel because it's my goal to make you a better investor. Also, check out this other video here on Charlie Munger's advice on how to get your first one hundred thousand dollars and why that will change your life. As always, thanks for watching, and talk to you again soon.