Your Financial Security Depends On Your Investor Type. Learn The Three Types of Investors — And How You Can Advance Your Investment Strategy To The Next Level.
After years of educating clients to properly design their own investment plans, I’ve noticed there are three distinct types of investors.
Type 1: Pre-Investor
Type 2: Passive Investor
Type 3: Active Investor
So what type of investor are you and why should you care?
Identifying your investor type will help you know the consequences of your investment style. You will learn the limitations and advantages that naturally result from the way you invest. Additionally, by understanding what the next level of investing looks like you will be able to decide if the opportunity is worth the effort required to take the next step.
There is no right answer to the question, “What is the best investment type?” However, there is a one right answer uniquely suited to your situation. Only one investment type is appropriate for your plan to achieve wealth, and your job is to determine what that type is.
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 that no matter what type of investor you are now the next level is just a little practice and education away.
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 do … a pre-investor. A pre-investor is simply someone who isn’t investing.
Pre-investors are characterized by minimal financial consciousness or awareness. There is little thought of investing, and there is correspondingly little savings or investment to show for that minimal thought. Some pre-investors have a company retirement plan, but that wouldn’t exist either had the personnel department not set it up for them.
“The trouble with being poor is that it takes up all your time.”
Willem de Kooning
The pre-investor’s financial world is primarily about consumption which takes precedence over savings and investment. As wage earners they typically live from paycheck to paycheck believing their financial difficulties will be solved by the next pay increase. When pre-investors earn more they just spend more because lifestyle is more important than financial security.
For whatever reason, pre-investors have not woken up to the necessity of owning financial responsibility for their lives and their future. This is not to judge all pre-investors harshly because it is perfectly acceptable for a seven year old to live in this reality. It is quite another thing for a 40 year old to have never graduated beyond it.
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 passive investing so that you can move beyond financial dependence and get on the road to financial independence?
Investor Type 2: Passive Investment Strategy
As we mature and gain responsibility, most people graduate and enter the investment world through the window of passive investing. It is the most common starting point on the road to financial security.
“Whenever you find that you are on the side of the majority, it is time to reform.”
Most of the financial institutions, educational services and web sites specifically support passive investing. 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.
Passive investing includes all the basics of sound personal financial planning: own your own home, fund tax deferred retirement plans, asset allocation, and save at least 10% of earnings. If you follow these foundational principles and begin early enough in life then passive investing is likely all you will 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 is difficult to make investing a top priority despite its financial importance.
A common result of this time limitation 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 is nothing wrong with any of these strategies: they just have consequences. You can become very wealthy given sufficient time, discipline, and regular contributions to an investment portfolio following the passive investment style, but you will take a lot more risk and can expect lower returns than investors who have reached the next level of investing.
The problem with passive investing is the lack of “value added” based on the skill of the investor to the return equation. Passive investors are dependent on the opportunity in the market for returns. 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 willfully bets his financial security on the hope that the roller coaster will end higher than when he started. You can learn more about the buy and hold investment approach here.
“Most people spend more time planning their vacations than their financial future.”
While passive investing is not without its flaws, for many the advantages outweigh the disadvantages making it the right course of action. Passive investing is far superior to not investing at all because 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 is passive it lacks many risk control strategies and overlooks value-adding opportunities available only to those with greater skills. The result can be 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 by taking the process to the next level and treating their wealth as their 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.
“By the time we’ve made it, we’ve had it.”
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 is 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, and 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. It is not so important how much you earn that will determine your wealth, but how much your money earns and how long it compounds that will ultimately determine your wealth.
Active investors have embraced full responsibility for their financial future by not just 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 is identical to the competitive advantage an entrepreneur seeks in business.
Without getting too complicated, suffice it to say 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. Below are some examples of active investing where real people are putting this equation into actual practice.
Active Investment Strategy Explained
Warren Buffett and Benjamin Graham were excellent examples of active investors in the stock market. They knew the stock market was inefficient and built vast fortunes applying their analytical skills (edge) to find value in securities that the market had under-priced (inefficiency). Contrast the return from their active portfolio management with the passive return from buying and holding index funds over the same time period and the value added from active investment strategy becomes clear.
Real estate is an active investors dream because of vast inefficiencies in price, usage, and management. For example, I know someone who buys large homes on large lots with separate “granny quarters” and then legally separates the properties into two titles and sells them for a fat profit. The same thing can sometimes be done with houses that are sold with additional land attached.
“Tradition is what you resort to when you don’t have the time or the money to do it right.”
Kurt Herbert Alder
Or maybe you’re a real estate investor who has an eye for mis-priced homes where you can add value with a few minor improvements. Add a few windows, remodel the kitchen, and presto; you have instant equity greatly in excess of what it cost to do the work. Sometimes, all you have to do is clean the property and make it presentable to add value and exploit how the property’s price did not reflect its true value (inefficiency).
In mutual fund switching, I know people who have built wealth by exploiting the pricing inefficiencies resulting from GAAP accounting rules. GAAP requires mutual funds to price every security at its last trade. The problem is many individual bonds in a bond fund’s portfolio don’t trade every day. Or what about the international fund with securities that are trading across time zones? Many low risk, fortunes have been built by trading the disparity between reported prices in mutual fund NAV’s and known values based on actual market conditions.
Whether its value investing in stocks like Graham and Buffett, or real estate conversion/rehab, or even mutual fund switching, these are just three examples of the many ways active investors profit by exploiting inefficiencies in a business-like fashion. The true number of active investment strategies is virtually limitless.
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?
“Opportunities are usually disguised as hard work, so most people don’t recognize them.”
The price the entrepreneurial investor pays for the extra profit and reduced risk is the time and energy required to exploit the inefficiency. It takes effort to treat your wealth as your business and that is why most people remain passive investors. In fact, in a classic “Catch-22”, active investing may be valuable to attaining financial freedom because of the potential for higher returns, but it is also the antithesis of financial freedom once you attain wealth because it can be as much work as a regular job. Passive investing is a lot less work and far less complicated.
Which Investment Strategy is Right For You?
There is no such thing as the “best investment strategy”. Each type of investing has its trade-offs and there is no single answer that will be right for everyone.
For example, some people have successful businesses and need to focus their energy on growing their business so they should not be distracted by the time commitment necessary for active investing. Other people with lower incomes or who begin investing later in life have little hope for a secure retirement without the benefit of an active investment strategy. Active investing can become virtually a necessity if your time horizon to retirement is only ten to fifteen years and you are just getting started.
“Wall Street is the only place that people ride to in a Rolls-Royce to get advice from those who take the subway.”
Each person is unique and has an appropriate investment style at an appropriate time for them. Many people naturally progress through each of the three types of investing as their skills, experience, and portfolio grow. Sometimes successful entrepreneurs choose to become active investors as a second career later in life to enhance and secure their nest egg. The point being there is not a single “right” answer to investment strategy, but there is one right answer for you.
FinancialMentor.Com is dedicated to helping you take that next step to the investment level that is right for you regardless of where you are at now. In fact, the Seven Steps to Seven Figures curriculum was specifically designed to offer you the next step in your financial education regardless of your level today.
We offer courses for pre-investors that help them commit to achieving financial freedom and stay with the program long enough to succeed (Steps 1-3). We offer courses that teach the right and wrong way to practice passive investing (Step 5), and we offer courses that teach you the skills necessary to become a successful active investor (Step 6). All the steps combined provide a start-to-finish blueprint for achieving financial success.
In Summary: Three Types of Investment Strategy
There are three types of investors: pre-investor, passive investor, and active investor. Each level builds on the skills of the next level below it. Each level represents a progressive increase in responsibility toward your financial security requiring a similarly higher commitment of effort. The advantage is each level offers a similarly higher level of potential reward and reduced risk for the effort expended.
Below are four questions to help you decide what type of investment strategy is best for your personal situation.
- Do I have the time and desire to learn the skills necessary to become an active investor?
- Do I have the stomach to tolerate the roller-coaster ride and potentially lower returns that come with the convenience of passive investing?
- What is my primary goal from investing: to enjoy the financial freedom I already attained or compound my savings to reach financial freedom ASAP?
- Do I have enough years prior to retirement and sufficient savings already put away to rely on passive investment returns for a secure retirement, or do I require a higher level of return to meet my retirement goals?
“Money is better than poverty, if only for financial reasons.”
- What difference would it make in my financial future if I could create higher returns with less risk thus compounding my wealth much more rapidly? What would that be worth to me and how should I prioritize it as a goal?
The choice is yours. What type of investor are you going to be? What are you going to do about it today? A financial coach can help you sort these questions out saving you time and money on the path to financial freedom…