Chapter 2: The Berkshire Hathaway Model
Before we continue discussing Passive Income, I think you will appreciate learning about the secrets of Warren Buffett in bringing success to his company Berkshire Hathaway. Back in the 1960’s, the value of Berkshire Hathaway’s stocks was only at $8. Today, the value of the company’s stocks is more than $100,000. In one of his current shareholder letters, Warren Buffett explained how he and the management team focus on two value “buckets” for the company. The 1st bucket is composed of several operating businesses that Berkshire Hathaway owns a controlling stake while the 2nd bucket is composed of other investment vehicles such as stocks, bonds and mutual funds.
The two-bucket strategy gives Berkshire Hathaway the following two key benefits that allow the company to achieve success:
- When the stock market crashes down, Warren Buffet is able to depend on the cash inflows produced by the various operating businesses of the company. He can then use part of those cash inflows to re-deploy funds into the stock market and buy stocks or other assets at a very cheap price. This will not have been the same case had Warren Buffet decided to put all of the company’s funds into mutual funds, stocks and bonds. When the stock market crashes down, the value of all these holdings will come crashing down, as well. He would have been compelled to sell some of his investments which were already under-valued in order to purchase other assets or investments that were even more under-valued.
- Except for the operating businesses with parent holding companies who have public stocks, all the other operating businesses owned by Berkshire Hathaway are basically shielded from day to day appraisals. This fact makes those operating businesses to have a lot more secure net worth and projected value in the private market. Stocks, bonds and mutual funds can have very volatile market value. This is the reason why banks and other credit institutions are more inclined to offer long-term loans with fixed rates to a more established and secure business who owns real assets like factories, buildings, retail stores and vehicles. A company whose majority of assets is invested in a portfolio of stocks, bonds and mutual funds may not be able to enjoy such debt leverage.
You can apply the same two-bucket strategy in your own life. You will be able to find it a lot easier and quicker to increase your personal net worth when you create two sources of income – active income and passive income.
For a lot of people, their day jobs are considered as their principal “operating business”. No matter what your profession may be – teaching, firefighting, accounting or even as a part-time restaurant waitress, your income from your day job enables you to pay your monthly rent and utility bills, buy your groceries, pay for your other necessities. This source of income can also provide you with the actual capital that you can use to get into real investments.
You need to treat your finances as your own business and as a business owner, you would want to make sure that you are able to increase your profits, which in this case are your income from both active and passive sources, while using the most minimum investment required. If you will be given a choice between working extended hours as a waiter to earn more money and continuing your studies to become a licensed physician, which will you choose? Well, you may choose continuing your studies because it can allow you to have more earnings in the future compared to working in double or triple shifts as a waiter. And here you will learn the golden rule in building wealth in your life which is to prioritize investments in your own self if you truly wish to achieve financial freedom in your life. You need to continuously aim to gain new skills which you can utilize to make monetary gains.
There are a lot of specialized skills that you can choose from depending on your abilities and interests. You can choose to become a neuro-surgeon, auto mechanic, dentist, plumber or fluent French speaker. Practically every one of us has the potential of adding unique and distinctive skills into our occupational toolbox in order to get ahead in life. We can no longer live inside the dream world where we can simply graduate from high school, look for employment, work until retirement age and enjoy your old age in abundance and peace. That dream world no longer exists especially with the continuous globalization of our economy. You can no longer escape reality.
After you have ensured that your primary or active career is right on track and you are making continuous investments in your own skills, you can then start acquiring and establishing your other sources of income, again choose something that matches your skills and interests. Your choices could include buying an unused building to convert into storage units or starting a car wash or lawn mowing business. If you like baking, you can start selling cookies and cakes. You just have to make your interests and skills into money-making machines that can help you build wealth so that you will no longer have to worry about your finances. It is also a great chance for you to earn more money by doing something that you are truly interested in. When choosing additional sources of income, find those things that can make you feel excited and happy.
You may think earning an extra $100 each week may seem insignificant but if you look at it from a long term perspective, it can tally up to become almost $10 million in 40 to 50 years if you invest it in a Roth IRA that can earn the historical 11 percent interest rate that the S&P has provided its shareholders in the long run. Imagine that by simply doing something that you truly enjoy and love and investing your earnings into assets that can earn you more profits, you can definitely enjoy a wealthy retirement. You may ask, what will happen to that new house, the new car or the new clothes that you want to buy now? Well, that is the reason why you should continue doing your primary or your active job and making investments in your personal skills.