Active vs Passive: Which Investment Is Right For You?

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I often get asked out to lunch by friends & associates who are contemplating buying a house to rent out or to fix up and sell, also known as a “flip”. These are typically smart, successful people with good jobs, spare money and the brains pull it off.

So what do I tell them?

Usually it’s something like, “take your money, give it to a qualified investment professional, have said professional spread it over a bunch of solid mutual funds, reinvest all dividends and capital gains, and let the magic of reinvesting do the rest”.

This is never the answer they want. They probably would like something more along the lines of “owning rentals and flipping homes is easy and fun and everyone should do it – including you!” Unfortunately, this simply is not true. In fact, the opposite is true. The vast majority of people should never put their money into an active investment, like a piece of real estate. Instead, they should be putting this money into something more passive, like a mutual fund. Why? Simple: Active is riskier, and the returns on the real estate are no where near high enough to justify the added risk.

Cheeseburger

[Editor’s Note: Who says there’s no such thing as a free lunch]

I’m pretty sure there’s never been a 10 year period where the stock market has lost money. Especially with a strategy of investing in solid mutual funds and reinvesting all gains. Over time, this strategy will earn you a significant return, with very little risk. The same cannot be said of owning real estate.

Owning real estate brings on tons of added risks and most people either don’t foresee these risks, or they aren’t able to handle them when confronted (vacancy, major mechanical, rent loss, legal, maintenance, management, code, weather, damage, etc). Hiring a management company can sometimes help, however their help will eat into your bottom line, and they are not guaranteed to keep the place rented. Often times even just one month of vacancy can be a crushing blow to your ROI.

Flipping is an even worse choice than renting, as there are certainly no guarantees that you can sell the home. You have a time value of money factor working against you from the moment you first buy the home and every penny that you invest is at risk that you won’t get it back, or won’t get it back in time to make it worth your while. This money is much more beneficial to you in a mutual fund.

Sure, there can be some no-brainer type home runs in both the rental and flip markets, but these are few, far between, and typically scooped up by the pros. There are also exceptions to these rules, but for the vast majority of people they do not apply. Just like some of my friends who are professional lawyers, doctors, bankers, golfers, etc, there are professionals in the real estate market. I don’t advise that the real estate pros start giving golf lessons on the side, and the same logic is why I don’t advise that a professional golfer try to be a part-time landlord.

While being a landlord or flipping houses can seem like a reasonable way to invest your spare money, it’s much more complicated than that. Resist the urge, and instead, start to build yourself a mountain of cash. Twenty years from now you’ll be glad that you did.

A-Mountain-of-Cash

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About donniccolo

Logic. Common Sense. Open Minds. www.nicknicastro.com
This entry was posted in Common Sense, Finance, Miscellaneous and tagged , , , , , , , , , , , . Bookmark the permalink.

5 Responses to Active vs Passive: Which Investment Is Right For You?

  1. Esther Nicastro says:

    Nick, Really good article…I don’t know how you do it. Sometimes, you sound like you should be a professor, 🙂 We’ve had this talk before & this is exactly what you’ve always told me. Also, love the pictures, esp. the mountain of cash!!!

    Like

  2. As a primary investment, I concur. However, REIT’s or actual real estate can be a nice option as an alternative investment for those who are more risk neutral and have a solid passive portfolio in place. With rates where they are currently, required return is much less than in the past and prices are rising. Some of the largest investment houses in the world (think Blackrock) have been buying up as many homes as they can due to the low price and resulting high cap rates. That being said, the real estate market has rebounded and prices are no longer depressed, now might not be the best time. Interest rates will be rising (can’t go any lower) and home prices will move inversely. Ebbs and flows my man, gotta stay informed to chase that alpha!

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    • donniccolo says:

      I agree, but who’s risk neutral these days! Combine the added risk with the lower required returns, with the soccer-mom realtor market (future post about realtors) overpricing things, and it’s just so hard for the average (read: non-professional) to own r/e.

      Why not just buy a REIT or mutual fund that heavily invests in r/e?!

      Like

  3. Pingback: Why Become A Landlord? | logical thinking in an illogical world

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