Active or Passive: Do You Know Your Investor Type?
Investing legend Benjamin Graham (a mentor to Warren Buffett) divided investors into two categories:
- Passive (defensive) investors
- Active (aggressive) investors
Do you know which one you are? Whether you invest in real estate or something else, this is an important choice.
According to Graham in The Intelligent Investor, passive investors want “freedom from effort, annoyance, and the need for making frequent decisions.” In other words, they value their time and freedom more than extra investment returns.
Active investors, on the other hand, are willing “to devote time and care to the selection of securities [investments] that are both sound and more attractive than the average.”
Active investors make a job out of investing, whether it’s part-time or full-time. They tend to love the details of the game of investing, and as a result they enjoy the sometimes tedious process of finding the best investments.
There is no right or wrong answer choice between active or passive investing. There are benefits and drawbacks to each. In this article I want to help you get clear on which is right for you.
Why Be a Passive Investor?
There are many reasons you may choose to be a passive investor. And it’s not a permanent decision. You may switch between active investing and passive investing at different times of your life.
You might choose passive investing because you don’t have the time available to be more active. You may spend all of your time with a job, with a family, or with other activities.
Or you might choose passive investing because your job is more profitable than active investing. If you are a high-earner in a busy period of your career, your job’s earning power can actually be a much better investment engine than active investing, even with lower investment returns.
Let’s say, for example, a doctor has a choice of how to spend an extra 10 hours each week. She could use them to actively invest or she could bill those 10 hours at $200 per hour.
$200 x 10 hours = $2,000 per week or over 50 weeks an extra $100,000 per year (pre-tax)!
If the doctor had a $500,000 portfolio of investments to manage, she might be able to invest passively and earn an investment return of 7% over the long-term. Even if she was able to DOUBLE that performance with a 14% return by actively investing, the difference of 7% only represents $35,000 (7% x $500,000) in extra investments earnings in year #1.
Even if she loses 50% of her $100,000 to taxes, the remaining $50,000 is still a better return on her time than $35,000 in a best case active investing scenario. And if she maxes out tax deferred investing strategies with that extra income, she’ll be even further ahead.
You might also choose passive investing because you’re ready to retire, to semi-retire, or to take a mini-retirement. If you already have a large portfolio, it’s time to begin asking why you invested in the first place. After all, is more money the means or the end?
Whatever reason causes you to lean towards passive investing, it can be a very reasonable and profitable choice if you build your investment strategy with this approach in mind.
What Are Passive Investments?
No investment is completely passive. You must always keep an eye on your investments and make adjustments from time to time. But passive investors choose investments that minimize the hassle and effort in this process.
With publicly traded investments, passive investors tend to gravitate towards simple but effective strategies like index investing.
Warren Buffett, probably the best investor of all time, told passive investor and multi-millionaire NBA star LeBron James to simply invest his millions in a low-cost index fund, like the S&P 500 Index from Vanguard. Buffett gave the same advice to the heirs and trustees of his multi-billion dollar fortune.
With more entrepreneurial investments, like real estate, passive investors tend to become private lenders or owners of very stable, quality rental properties.
My own private lenders have chosen to loan my company money in order to passively and securely receive interest income. They forgo greater potential returns in other investments for the ease, regularity, and security of investments in my properties.
Successful investor and teacher John Schaub in Sarasota, Florida has been an investor for 40+ years. But he now chooses to invest more passively in about 30 single family houses in the median to upper-median price range because they allow him to make the the most money for the least hassle and time. His tenants almost manage themselves and stay in his houses for many years.
Keep in mind that passive investing does not imply ignorant investing. Any passive technique you choose still requires a sound strategy, education, discipline, and emotional fortitude.
Why Be an Active Investor?
Why should you be willing to devote extra time and effort as an active investor? In short, you may be rewarded for your efforts.
My situation does not necessarily directly translate to yours, but I feel very confident that I can achieve reasonably safe returns on my investment exceeding 15-20% by acquiring solid real estate investments. These returns don’t necessarily come easily. But I can get them because of my investment in knowledge, my willingness to hustle, and my relationships with key team members who help me to succeed.
Over a twenty year period let’s look at why those numbers are meaningful.
Here are my assumptions:
- Beginning capital (PV)= $100,000
- Yearly new invested capital (Pmt) = $10,000
- Number of years (Periods) = 20
- Annual return (Rate, after tax) = 15%
After 20 years I could accumulate $2,661,089 as a result of these active investments. If you’d like to see how I calculated this number, use this online financial calculator and solve for FV using the figures above.
If I had invested the same amount over 20 years and only achieved a 7% return, my future wealth would only be $796,923.
The difference between the two scenarios is over $1,864,166 in my final net worth!!
If in the end I chose to become a passive investor and lend my money to other real estate investors at 7%, that additional net worth equates to over $10,800 per month in additional interest income as a result of active investing. That extra money can make a BIG difference in your life.
Or you might choose to become an active investor because you’re someone who does not earn hundreds-of-thousands per year or have growth opportunities at a job. If your job has an income ceiling, becoming an active investor on the side makes a lot of sense.
Or you might choose to become an active investor because you time is short, you need extra investment growth, and you’re willing to work for it. Plenty of late-in-life investors lacking a sufficient financial cushion have actively invested in real estate to secure their retirement.
Finally, you might choose to become an active investor because you just love the game of investing. Doing what you love is a reward in and of itself. But it becomes even more rewarding if you can use your active investment skills to maximize investment growth for yourself AND for potential passive partners and lenders who will benefit from your efforts.
After all, Warren Buffett himself is an active investor, and he certainly doesn’t need the money. He often says that he loves his job so much that he “tap dances into work each day.” And in the process of becoming very rich for himself, he also enriched the people who invested their money with him.
What Are Active Investments?
There is not a clear line between active and passive investments. Sometimes it’s a matter of timing.
For example, the most profitable real estate investments my partner and I have ever purchased were called “value added” real estate. This means there was something wrong with the property, the financing, the owner, or all of the above. We added value to the situation by solving those problems with our knowledge and our efforts.
My mentor and friend Louis Stone calls these investments good dogs with fleas. Once you remove the fleas, the good dog is as cute and lovable as ever!
These value added deals are very profitable. But they typically require more effort and time up front in order to solve the problems.
The good news is that once the problem is solved, the investment can become more passive. We can either keep it ourselves and harvest the fruits of earlier efforts for many years. Or we can make our profits now by selling the property to a passive investor or to a homeowner, depending upon the situation.
In the world of publicly traded stock and bond investing, similar “dogs with fleas” can be found. Value investors have been buying bargain stocks and bonds for as long as investing has existed.
Warren Buffett and Benjamin Graham are the most well-known examples of value investors, but an entire line of investors with similar philosophies have proven the general approach successful. Read the classic essay by Warren Buffett called “The Superinvestors of Graham-and-Doddsville” to learn more about the performance of active value investors over many decades.
I am certainly not an expert in this arena of value investing with stocks and bonds. I have found that the same approach within real estate investing is a much easier task.
To Be Passive or Active, That is the Question
The decision to be a passive or an active investor is a personal decision. It’s important to consider your strengths, your weaknesses, and your talents before making the call.
It’s also helpful to consider the landscape and the season of your life and career. Active investing may make sense for a period, and later on passive may make more sense.
If you have a difficult time being objective about life and investment decisions like this, it might be good to find a mentor or an adviser. This can be an informal mentor who you already know, or it could be someone who you respect and trust that you pay for advice.
Whatever you decide, get educated about a solid investment strategy within your passive or active approach. There are no shortcuts. You will get back in proportion to what you put in.
Best of luck with your passive or active investing!
Do you tend towards passive or active investing? What investment vehicles do you focus on? Have you switched between active and passive investing at some point in your life? I’d love to hear from you in the comments below.