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Here's the most overlooked fact about how Warren Buffett amassed his fortune, says money expert

Warren Buffett
Adam Jeffery | CNBC

Small changes in growth assumptions can lead to ridiculous, impractical numbers. So when we're studying why something got to become as powerful as it has — why an ice age formed, or why Warren Buffett is so rich — we often overlook the key drivers of success

Let's go back to Buffett: Currently, at 90, he has a net worth of more than $81 billion. A large portion of that, however, was accumulated after his 50th birthday. And $70 billion came after he qualified for Social Security benefits, in his mid-60s.

That said, those who attach all of Buffett's success to investing acumen miss an important point. The real key to his success is that he's been a phenomenal investor for three quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him.

Warren Buffett: A thought experiment 

Buffett began seriously investing when he was 10 years old. By the time he was 30, he had a net worth of $1 million, or $9.3 million adjusted for inflation.

But what if he was a more normal person, spending his teens and 20s exploring the world and finding his passion — and, by age 30, his net worth was, say, $25,000?

And let's say he still went on to earn the extraordinary annual investment returns he's been able to generate — 22% annually — but quit investing and retired at 60 to play golf and spend time with his grandchildren?

 What would a rough estimate of his net worth be today?

 Not $81 billion. 

$11.9 million (99.9% less than his actual net worth). 

Effectively all of Buffett's financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. 

That's how compounding works. Think of this another way: Buffett is the richest investor of all time. But he's not actually the greatest — at least not when measured by average annual returns. 

Jim Simons, founder of the hedge fund Renaissance Technologies, has compounded money at 66% annually since 1988. No one comes close to this record. As we just saw, Buffett has compounded at roughly 22% annually, a third as much. 

Simons' net worth, as I write, is around $23 billion. He is 72% less rich than Buffett. 

Why the difference, if Simons is such a better investor? Because Simons did not find his investment stride until he was 50 years old. He's had less than half as many years to compound as Buffett. Had Simons earned his 66% annual returns for the 70-year span Buffett has built his wealth, he'd be worth — please hold your breath — $63,900,781,780,748,160,000.

Always consider compounding potential

I've heard many people say that the first time they saw a compound interest table (or one of those stories about how much more you'd have for retirement if you began saving in your 20s versus your 30s) changed their life. But it probably didn't.

What it likely did was surprise them, because the results intuitively didn't seem right. Linear thinking is so much more intuitive than exponential thinking. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it's 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it's 134,217,728).

The danger here is that when compounding isn't intuitive, we often ignore its potential and focus on solving problems through other means — because we're overthinking, but because we rarely stop to consider compounding potential.

Good investing isn't about earning the highest returns

There are books on economic cycles, trading strategies and sector bets. But the most powerful and important book should be called "Shut Up And Wait." It's just one page with a long-term chart of economic growth. 

The practical takeaway is that the counterintuitiveness of compounding may be responsible for the majority of disappointing trades, bad strategies and successful investing attempts. 

You can't blame people for devoting all their effort to trying to earn the highest investment returns. It intuitively seems like the best way to get rich.

But good investing isn't necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can't be repeated. It's about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That's when compounding runs wild.

Morgan Housel is a partner at The Collaborative Fund, behavioral finance expert, and former columnist at The Wall Street Journal and The Motley Fool. He is also the author of "The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness." Follow him on Twitter.

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