Your world to financial freedom begins with your investment strategy and how determined you are to bring it to realization. There’s no right answer to the question, “What is the best investment type?” However, there’s a right answer uniquely suited to your situation. Only one investment type is appropriate for your plan to achieve wealth, and your duty is to determine what that type is.
There are three types of investors, but only one type is right for you.
The nice thing about investor types is we all start in the same place (pre-investor), and we can all graduate to the next successive level of investment skill through education and experience. Each investment type builds on the skills of the type below it. So no matter what type of investor you are now, the next level is just a little practice and education away. You must carefully match your investment strategy with your skills, resources, and interests if you want to achieve your financial goals as easy as possible. Surprisingly, many investment strategies won’t fit your financial situation. The good news is you can advance to another investment type with the right education and skill development.
INVESTOR TYPE 1: PRE-INVESTOR
Unless you were born with a silver spoon in your mouth and a trust fund to match, then you likely began life as most of us did: a pre- investor.
A pre-investor is simply someone who isn’t investing! Pre-investors are characterized by minimal financial consciousness or awareness. There’s little thought of investing, and there’s correspondingly little savings or investment to show for that minimal thought. Some pre-investors have a company retirement plan, but that wouldn’t exist had the personnel department not set it up for them.
The pre-investor’s financial world is primarily about consumption, which takes precedence over savings and investment. As wage earners, they typically live paycheck to paycheck believing their financial difficulties will be solved by the next pay increase. When pre-investors earn more, they spend more, because lifestyle is more important than financial security. For whatever reason, pre-investors haven’t woken up to the necessity of owning financial responsibility for their lives and their future. This isn’t to judge all pre-investors harshly because it’s perfectly acceptable for a seven year old to live in this reality. It’s another thing for a 40 year old to never graduate beyond it.
Ask yourself these real questions in your quest for financial freedom:
- Are you a pre-investor?
- How is your savings and investment plan progressing?
- Is your financial consciousness ruled by consumption needs, or are you prioritizing savings and investment?
- What are you going to do to take the next step and begin passively investing so that you can move beyond financial dependence and get on the road to financial independence?
Once you are able to respond to these questions above then your journey to financial freedom has commenced.
INVESTOR TYPE 2: PASSIVE INVESTMENT STRATEGY
As we mature and gain responsibility, most people graduate from pre-investor status and enter the investment world through the window of passive investing. It’s the most common starting point on the road to financial security.
Most financial institutions, educational services, and web sites support passive investing as the proven, accepted solution. Most of what you can learn from the information available in your local bookstore or on the internet is the conventional wisdom of passive investment strategies. Passive investing is where the retail world of investing lives. While there are no hard statistics to support my claim, I believe well over 90% of all investors fall into the passive investor category.
The passive investor type usually employs all the basics of sound personal financial planning such as:
- own your own home
- fund tax deferred retirement plans
- asset allocation and
- save at least 10% of
If you follow these foundational principles and begin early enough in life, then passive investing is likely all you’ll ever need to attain financial security. Passive investment strategy is good for people with busy lives, families, jobs, outside interests, or entrepreneurs building businesses. Let’s face it: most people’s lives are already full, leaving little time for developing investment skills. It’s difficult to make investing a top priority despite its financial importance. A common result of having limited time is passive investors often delegate the responsibility and authority for their investment decisions to “experts” such as financial planners, brokers, money managers, or even newsletter writers. Rather than become their own expert on investing, passive investors typically rely on other people’s expertise for their investment strategy.
The defining characteristic of passive investment strategies are their simplicity. They require less knowledge and skill making them accessible to the general populace. “Buy and hold” with mutual funds or stocks, fixed asset allocation, averaging down, and buying real estate at retail prices are all examples of passive investment strategies.
There’s nothing wrong with any of these strategies, but they can have negative consequences. Sure, it’s possible to become acceptably wealthy, but the downside is it usually requires a working lifetime combined with discipline and regular savings contributions to achieve financial independence using the passive investment style. The one exception is extreme frugality because of the high savings rates and low spending rates that accelerate the timeline.
The other downside to the passive investment strategy is you’ll take a lot more risk and can expect lower returns than investors who have reached the next level of investing. That’s because passive investors have no “value added” or skill component to their expected return stream so they’re dependent on the opportunity in the market for investment return. Rising markets provide great returns, and declining markets provide miserable returns.
The passive investor submissively rides the market roller coaster up and down into the future and wilfully bets his financial security on the hope that the roller coaster will end higher than when he started. While passive investing isn’t without its flaws, the advantages outweigh the disadvantages for many people, making it the right course of action for them. Passive investing is far superior to not investing at all as it starts the process of compounding returns on invested capital and has the lowest barrier to entry in terms of time and knowledge required.
If the simplicity of passive investing is necessary to get you started, then it is well worth the trade-offs because not getting started (pre-investor) is far worse. The disadvantage of passive investing is the lack of control over your financial security. Because it’s passive, it lacks many risk control strategies and overlooks the value-added opportunities available only to those with greater skills. The result is the passive investor type endures higher volatility and possibly lower returns when compared to the successful execution of an active investment strategy.
INVESTOR TYPE 3:ACTIVE INVESTOR
Active investors build on the foundation of the passive investor. They take the process to the next level by running their wealth like a business. The primary difference between active and passive investors is the active investor not only receives market based passive returns, but he also gains a value-added return stream based on skill; two sources of return in one investment.
This allows the active investor to make money regardless of market conditions or direction and to reduce losses during periods of adversity. This holds the potential to increase returns and lower risk. A primary distinction between passive and active investment strategies is passive investors work hard to acquire and save money, but spend far less energy making their money work for them. Active investors work just as hard at making their money work for them as they ever did earning it in the first place. In other words, active investing is more work, and that’s why it is not for everyone.
The reason active investors are willing to spend that extra effort is because they understand the wealth building game is about return on capital. Small differences in growth rates over long periods of time make huge differences in wealth– far bigger differences than could ever be realized by working toward the next pay raise.
The most important factor in building your wealth is not how much you earn, but how much your money earns and how long it compounds. Active investors have embraced full responsibility for their financial future by not only building investment capital as passive investors, but also taking responsibility for the return on their invested capital through active strategies that add value.
HOW DOES THE ACTIVE INVESTOR DO THIS?
By creating a plan that follows specific rules designed to exploit inefficiencies existing in the marketplace. The term for this is known as “edge” and it’s identical to the competitive advantage an entrepreneur seeks in business. The competitive advantage must add more value than transaction costs take away or you won’t profit.
Without getting too complicated, the only way to create an investment return in excess of market rates (passive returns) with consistency is if inefficiencies exist that can be profited from in a business-like fashion. Investment edge creates profits that are equal to the inefficiency afforded by the market after subtracting the cost to exploit the inefficiency.
In summary, the purpose of active investing is to lower risk and enhance returns by introducing the element of skill. By developing a competitive edge that profits from market inefficiencies, the active investor creates a return stream completely separate and in addition to what the market offers. This value added return stream lowers risk and increases return.
Isn’t that what investing is all about? The price the entrepreneurial investor pays for the extra profit and reduced risk is the time and energy required to exploit the inefficiency.