Active vs. Passive Investing - What's the difference and what's best for you?
Many of us are well aware that investing, not saving, is the path to building wealth. But how each of us go about it can be very different. Your investment approach should reflect your appetite to allocate your time, skills, and knowledge. In this article, we are going to review what is active or passive investing and 3 considerations when determining which might be best for you.
First let’s understand what active vs passive investing is.
Active investing is taking a hands-on approach to select and/or manage assets. This requires a higher commitment of time, skill, knowledge, analysis, experience, and more. Active investing would feel more like a part-time (or full-time) job.
Passive investing requires little, to no, day to day management. Typically, the passive investor does some work upfront to select the instruments, assets, or manager and then holds for a longer duration. See that we said, it does require some work upfront. Passive investing is not just throwing darts at a board. Passive investing should feel more like planting a seed and planning to simply watch it grow with time.
Examples - Advantages Disadvantages of Active Investing:
General Partner or Sponsor
Managed Mutual Fund
Looks to beat the market
Can be more tailored to specific goals
Active hedging and rebalancing
Typically more fees
Requires more time
Have to “beat the market” to provide value
Investing in index funds
Hiring a financial advisor
Limited Partner or Capital Provider
Intended to match market performance
Set it, and forget it
Longer hold periods, typically taxed lower than shorter (<1 year) holds
Still requires upfront active selection
May not be as intimately familiar with holdings or activity
Fees can be indirectly paid to the active manager, if there is one
It's also important to realize that although the investor themselves may not be active, they could choose to invest in an instrument, portfolio, fund, etc. which is actively managed. And this might be the sweet spot for many investors.
Let’s take a look at our favorite investment vehicle – private equity real estate:
These transactions typically have a group of active investors who are referred to as the General Partners (GP) or Sponsors. This group has a massive amount of responsibility in putting together the deal and managing it through the life of the investment. Some of these activities include researching markets, sourcing the deal, underwriting, performing due diligence, obtaining financing, reviewing documents, hiring and managing a team of professionals such as accountants, lawyers, property managers, general contractors, maintenance staff, leasing agents, overseeing property improvements, putting together the operating financials, dealing with tenant issues, preparing the property for sale, etc. As you can see this is certainly an active role.
All the above may sound overwhelming and/or you may not want to spend your time doing those things, but still want the benefits of owning real estate.
The passive side of private equity real estate are the limited partners (LP). Investing as an LP is providing capital to the deal in return for a share of equity ownership. You would still get all the amazing financial benefits of owning real estate (cash flow, appreciation, tax benefits, loan paydowns) without the old landlord adage of tenants, toilets, trash. And it is not just the freedom of time and fewer headaches that is enjoyed on the LP side, but you will also benefit from leveraging the experience of the skilled GP investors. It takes a lot of time and immersions into the real estate world to gain that experience. LP investors can bypass that and instead choose to partner with GPs who bring that to them.
Now let’s consider how to determine which investing strategy is best for you, at this moment.
Consideration #1 – Wealth comes in many forms, not just financial (health, time, relationships, knowledge freedom). Which is most important to you right now?
This rule is the most vital to ask yourself upfront because without this, you cannot answer the passive vs active question. It’s important to realize that financial goals are often a means to achieve another form of life wealth. Want to spend more time with your family, reach certain health markers, spend more time hiking or on a beach, get closer to certain people, experience certain things or learn other new things. What form of wealth is most important to you at this moment? Which are you willing to sacrifice? It requires a lot of self-reflection of your values and where you are in life because you will most certainly have to sacrifice one or multiple to grow in others. But the answers to these questions will guide you on which path to take on your investing journey.
Consideration #2 – Do you have skillsets/knowledge or wish to acquire such that can enable you to “beat the market?”
Active investing is an attempt to beat the market. You are trading time for a potential higher return. Therefore, it is best that you have an advantage to achieve those returns higher than the market. That advantage is usually through a skill and or knowledge which sets you above. Alternatively, you may not have either of those yet but wish to build towards it. Therefore experience would be considered an additional return to you, not just the financial returns when investing.
Consideration #3 – How much capital do you have to start with and how much time is needed to reach your goal?
In almost all cases, passive investing is allowing your money do the work while you sleep. But what if you don’t have enough capital to reach your goals in the time horizon you wish to. Then perhaps active investing can help boost your returns by involving your capital and/or time, skills, etc. Active investing could position you to gain valuable experience and others would pay to leverage from that experience (e.g. as the GPs in private equity real estate transactions). Therefore, there are also paths to actively invest without any of your own money. So, if you don’t have capital, but wish to start investing – you likely will have to trade your time, skills, or knowledge to attract the leverage of others capital or earn equity creatively.
Before starting to invest it’s important to reflect on your goals and priorities. There will be tradeoffs when considering to be active or passive in investing. Active allows those with time, skills, or knowledge to potentially capitalize on it in hopes for an incremental financial return. On the other hand, passive investing provides more freedom of time to the investor to focus on other endeavors while still earning strong returns. Often times investors will blend between the two based on asset class or at different points in their life. In the end, just ensure you are being intentional about your choice and what fits for you.
This article was written as part of the Multifamily Scrum series with credit to Matt Acquino.
If you'd like to learn more about Multifamily investing, please contact us.