What is better Active Investing or Passive Investing?
Which is better; active investing or passive investing? To truly determine the answer to that question we would need to dive deeper into the what the definition of active investing is and what the definition of passive investing is.
Active and passive investing are relevant terms to whatever asset class you choose to invest in whether stocks, businesses, precious metals, real estate and other investment asset classes. We will focus on real estate as the asset class of choice.
What does active investing mean? active investing definition
Active investing means what you probably think it does from a face value read of the word. You are taking an active role in your investing. This “hands- on” approach to investing is used when you are responsible for the success and failure of the investment based on your actions.
In active investing you (and any of your other active co-investors) are putting your, time, energy and resources into making sure that your investments and investment strategies provide returns that can out-pace inflation.
What is an example of active investing?
Imagine it has been a long week at work and you finally have some time off to spend with the family on a Friday night. You are sitting down to dinner at 8 PM when you get a cellphone call from your one of your tenants. When you pick up the phone you are greeted by the timely news that the boiler broke, there is no heat and hot water and it is the middle of winter.
You’ve got a problem. As a small-time landlord, you don’t have the systems built out or cash flow set to hire out management. Now you must rush through dinner and try and get a plumber out to the property and make a trip to the hardware store (if its even open) to try and find a solution.
If you’ve found yourself in this or a similar situation, where your investment has impacted your schedule you are probably actively investing.
What is an active investment strategy? types of active investment strategies
As we are talking about real estate – an active investment strategy would be where you are getting your hands dirty and doing the ground work to find, acquire, manage and dispose (or exit) of an asset once you have realized the pre-determined goal returns. This may take the shape of wholesaling, fix and flips, buy and hold rentals, short term rentals, being a general partner on a commercial real estate syndication and much more. We break down a couple of these active investment strategies below.
Wholesaling – Wholesalers make money via finding distressed properties and selling them to cash buyers (such as fix and flippers) in order to earn a fee for finding the property.
Fix and Flips – Acquisition of a distressed property, often a single-family home, at a discounted price in order to renovate the property and sell it for a profit within a short period of time (typically less than 1 year.)
Buy and Hold rentals – This strategy refers to individuals that acquire and manage rental properties (residential or commercial) to obtain profit from the rental income.
Short term rentals – Short term rentals such as Airbnb, VBRO etc. are more based on hospitality and travel and as such require an owner to operate their property more like a hotel where they accommodate guests for short periods of time typically less than 1 month. I separate this from buy and hold rentals as there has been a common trend for people to do short term rentals on properties they do not own.
What does passive investing mean?
Passive investing means that your actions are not responsible for the success or failure of the investment. It’s that simple. Once you start putting your hands on the investment to directly impact the outcome you are now a “hands on” investor; an active investor.
What is an example of passive investing?
Imagine that you are at your dinner table on a Friday night at 8 PM. It has been a long work week and the only thing you would like to do at this point is enjoy some quality time with your family. You get an email alert – it’s about your real estate syndication deal.
The deal sponsors just sent out a notice that quarterly distributions are being sent out and the cash should be in your bank for that month’s return. You read a little more down the email and see updates on the property – there was a massive HVAC break down and boilers needed to be replaced. The sponsor team worked tirelessly over the last weekend and were able to get the repairs needed done on the property. They were able to get everything up and running without missing a beat.
You smile as you see another alert, this time it’s from your bank, come into your phone confirming that the cash distribution reached your account. You turn the phone off and proceed to enjoy dinner with your family.
If you found yourself in this or a similar situation where you didn’t have to make the decisions or do the work to make your investment successful, you were probably investing passively.
What is a passive investment strategy? The types of passive investment strategies:
Passive investors can participate in all the forms of active investment strategies simply by providing the capital (but not the sweat equity, i.e. the work) needed for the investment to an active investor involved in their desired investment strategy. Since the active investor is the one that is doing the work and the passive investor is only receiving a return on their money this is truly a passive arrangement. In fact, if you think about this definition banks and other lending institutions are often the largest passive investors in real estate deals as they provide 70%-90%+ of cash needed but do not participate in the deal.
Private lending: You provide cash to a fix and flip or buy and hold investor (typically in the form of debt) and they provide an interest payment to you during the hold period of the property.
Passive Investing in Real Estate Syndications: Buying shares as a limited partner in an Limited Liability Company that will purchase a commercial real estate asset. Based on the deal and the number of shares (i.e. capital you invested) you receive ongoing returns and an equity split at the sale of the property.
REITS: These are stocks that are based on a portfolio of real estate investments. They share similar benefits of investing in the stock market with a few of the upsides of investing directly into real estate. You can read more on REITS here.
The Myth of Passive Investments
Many people have inaccurately labelled certain investments as passive investments when they are truly active investments. You may have been surprised at the example of a small-time landlord being considered an active investor. The reality is that if you are responsible for the success of the investment, no matter how small of a task or number of hours you are putting in, this is an active investment.
Passive investing can be thought of as a myth because so many people have the wrong definition of passive investing. In fact, everyone is an “active investor” to some extent. Those that truly do invest in passive investment vehicles are active during the due diligence phase where they decide if they want to invest or not. It is only after they make their investment do they truly start to live the passive income life.
If you have your investments in a managed account where someone is making the investment decisions on your behalf, then you may have a more passive arrangement. Even in this scenario however, you would want to keep tabs on the portfolio manager to make sure they are doing a good job. It is your hard-earned money after all, you want to know that it is invested wisely.
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