Passive vs. Active Management

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Which investment is going to make you rich, one that earns 10% or 11%? The answer isn’t that easy. Here are the details…

You have $10,000 to invest for retirement. You are trying to decide between a passive investment strategy, like a target retirement fund, or between actively managing your portfolio to beat the market.

To succeed in active management, you have to devote 5 hour a week, the entire year to research (Even though history tells us it’s impossible to succeed using active management year in and year out, bear with me for this example).

Instead of measuring only your return, you will also take into account your Time/Value return or T/V return. This return incorporates the value of your time. Therefore, if you were to value your time at $25 an hour, each hour of research should generate $25 in extra income.

Here are the results after year 1 if you combine the value of your time into your returns.

Investment	Principal	Time Investment	Return	Year-End Total	T/V Return at $25 a hour	T/V Return at $50 a hour
Target Retirement Fund	$10,000	1	10%	$11,000	$10,975	$10,950
Active Management	$10,000	260	11%	$11,100	$4,600	$-1,900

Opportunity Cost of Investing

Investment Principal Time Investment Return Year-End Total T/V Return at $25 a hour T/V Return at $50 a hour

Target Retirement Fund $10,000 1 10% $11,000 $10,975 $10,950

Active Management $10,000 260 11% $11,100 $4,600 $-1,900

This example is far from perfect, but the lesson learned is pretty clear. Invest your time in activities that will give you the greatest return.

Earning that 1% percent cost you an extra 259 hours of your time. Those 259 hours earned you an extra $100 at the end of the year. Unfortunately, that’s equal to earning about 26 cents an hour. Congratulations.

If those 259 hours were shifted from research which netted you $.26 a hour, to an activity where your time is worth $25 a hour, you would have an extra $6,408 at the end of the year.

A Smarter Way To Build Wealth

The major hole in my example is compound interest. After 40 years, an investment of $10,000 grows to $452,593 with a 10% return and $650,009 with a 11% return.

Investment	Years	Total Return	Time Investment per year	T/V Return at $25 a hour	T/V Return at $50 a hour
Target Retirement Fund	40	$452,593	1	$451,593	$450,093
Active Management	40	$650,009	260	$390,009	$130,009

Opportunity Cost of Investing W/ Compound Interest

Investment Years Total Return Time Investment per year T/V Return at $25 a hour T/V Return at $50 a hour

Target Retirement Fund 40 $452,593 1 $451,593 $450,093

Active Management 40 $650,009 260 $390,009 $130,009

I would still rather have the 10% return without the 10,400 (260 hours a year x 40 years) hours of my time invested.

Reason number one, if I truly value my time, my T/V return is still lower. Second, I can invest those 10,000 hours into making my time worth even more than it is now. For example, I could become the world’s foremost expert on a particular niche and make my time worth well over $1,000 an hour.

The more time you invest in the stock market, doesn’t equate to better returns. There are plenty of active managers who spend 70 hours a week reading about stocks, but still under perform the market.

The smart way to build wealth is doing so in things you can control. Concentrate on being able to create as much value as you can for other people.

Once you get compensated for the value you provided, invest it passively and get back to work.