This post is a continuation of our discussion regarding consistent 10% passive cash flow (Part 1).
We’ve already discussed that many investors want to turn their nest egg into a predictable stream of cash flow that can replace or supplement their active income.
So why is it so difficult for investors to achieve a satisfactory double digit return on their capital (after management expenses and preferably after taxes also) if they do NOT wish to take an active role in running a business?
Remember, all investments are ultimately tied to some underlying business which tries to generate revenue that exceeds the cost of capital invested.
We’ve all heard the overwhelming statistics of business failures, so a truly successful and profitable business is not something to be taken for granted. It is truly a remarkable feat for a business to take on investor capital, pay investors a good yield for their money, and still remain a consistently profitable business.
Active vs. Passive Investing – What’s the Difference?
A savvy entrepreneur can build a successful business with very little start-up capital and reap the highest reward for that investment. However, this requires talent, sweat equity and favorable market conditions, etc.
Now imagine a passive investor who does not want to be working in the business or on the business. The investor would need to hire someone else to do the management work required and pay them reasonable compensation. In this case the passive investor would get a lower return on his investment in the business than the entrepreneur who works in or on the business.
How about having yet another layer of indirection? Perhaps some “fund manager” that chooses businesses to invest in for you? Or, buying stocks (ownership) or bonds (debt) in the business on a publicly traded market where pricing for these “paper” derivatives of the business can be somewhat independent of how the business is actually performing?
You get the idea – chances are investors in “business derivatives” don’t do as well or don’t have as much visibility into the assets they indirectly own. All the layers of management will have to be paid off before the investor gets his return. As you all know by now, Wall Street is notorious for charging high fees regardless of the success (or most likely failure) of your investment.
Generally speaking, investment return decreases as more layers of “management” are added between the investor and the underlying asset (business). The investor also has less control over the underlying asset the further removed he is from the asset.
So, what does this mean for the passive investor’s quest to achieve consistent cash flow?
- Get as close to the underlying asset/business as possible without working in the business. Have a straight line of communication to the manager of your asset.
- Often, it is better for management to have vested interest in the asset and not just a “hired hand”. In other words, make your management team your partner, not your employee.
- Invest in distressed assets and partner with someone who knows how to “improve” the assets and realize their full potential, or be a lending partner (i.e. become a hard money lender).
- Consider investing in a proven business system (i.e. a franchise) to short cut the learning curve and outsource most of the management gradually.
- Allow the business to “incubate” before reaping the reward of consistent cash flow. You may need to invest more time and energy in the business during the incubation period.
- Ladder into fixed income type assets with different maturity dates.
- Invest in self-renewing assets (e.g. orchards, forests, producing oil wells, etc.) that can produce income for years after an initial setup period.
We will discuss some examples in more detail in Part 3 of this series.
Meanwhile, please share your thoughts, questions, and opinions by commenting below.ve
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Yes, perhaps an investor can achieve 10% return over the next decade through the stock market however that’s not the dream. Instead the investors dream is turning a large capital base into immediate cash flow that provides a check every month. That consistent, predictable, double digit return is almost impossible to find in a passive investment.
For people who don’t want to spend a lot of time looking and getting educated, the low cost ETF is probably the way to go. Warren Buffett has said that what he does is not for everyone. Instead for the vast majority investors Buffett says the best option is the lowest cost fund that follows the stock market up and down.
John Bogle thinks one can achieve 10% over the next decade just in the S&P500. A cheap index ETF can be a simple passive investment, too.
“The upside of the painful bear market, of course, is that stocks are much cheaper – as cheap, in fact, as they have been in many, many years. Based on the price/earnings ratio (using earnings from the past 12 months), the U.S. market is as inexpensive today as it has been since 1990. From today’s levels, says Bogle, it’s reasonable to think that the S&P 500’s profits could grow by 7% a year. Throw in the current dividend yield of over 3%, and Bogle believes stocks could return 10% a year for the next decade. “I don’t think that’s a pipe dream,” he says – and this from a man who at the turn of the century was warning of years of subpar returns.”