March 10, 2022

JF2746: 4 Rules For Professional Investors | Actively Passive Investing Show with Travis Watts



Want to enhance your professionalism and authority as an investor? In this episode, Travis Watts shares four ways you can elevate your knowledge, work ethic, and mindset to gain credibility as an investor.

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Travis Watts: Welcome back Best Ever listeners to another episode of The Actively Passive Investing Show. I’m your host, Travis Watts. I have another exciting episode for you all today, I titled it Four Rules for Professional Investors. Just because someone is an investor, it doesn’t make them a professional investor. I do think that there are some rules that could “be followed” to help you out, and that’s what we’re talking about in today’s episode. As always, my intent here is to bring you all as much value as I can, in as short of a timeframe as possible.

I’m just going to go ahead and dive right into number one, which is understanding active versus passive income. I’m going to give it to you in my own definition. I know there’s the technical definitions between the two, but just hear me out on this. The simplest way I can put it is active income is when you’re materially participating in the business of making the money. I’ll give you a couple of examples. Flipping a house would involve my time, my effort, my energy. Even if I’m not, say, the contractor that swinging the hammer or putting things together, I am still active in the business of finding that property, running the numbers, trying to work with realtors to list it when I’m done. I am actively participating. In my definition, that is active income. If I’m day trading stocks, for example, and I’m sitting in front of a computer a quarter of the day, half the day, all day, and I’m sitting here and I’m trying to look at trends and markets and graphs and charts and moving averages, and I’m trading in and out of stocks, I am making active income.

Now on the flip side, passive income is rolling in whether or not you actually work or put in any time. It’s something where you make a decision once, you put money somewhere once, and then for the rest of the time, money is coming back to you, whether or not you work. Again, you are not materially participating in the business itself. I’ll give you two quick examples, which would be as I do – I invest as a limited partner in multifamily apartment syndications.

The general partners are the active folks, they are finding deals, underwriting them, managing the business, doing investor relations, sending out distributions… I’m just the guy saying, “Here’s $50,000. I want to invest in that deal.” I sign some paperwork upfront; that’s about as active as that gets, and then the rest of the time is hopefully receiving cash flow distributions, passive income into my bank account.

Another example of being a hands-off or passive investor would be if I bought shares of a dividend-paying stock. We’ll use Coca-Cola as an example, because they have paid a dividend for a very long time, I think it’s a quarterly dividend. Again, I would do a little bit of homework, do a little bit of research, figure out maybe I want to invest in that stock. I make a one-time transaction and buy some shares; the rest of the time, I’m not working for Coca-Cola, I’m not the CEO of Coke, I’m not on their team, I don’t have to actively participate in the business of Coca-Cola in order to receive dividends by holding that stock. So that is passive income.

The big point and the big message I’m trying to make with this is it can be literally life-changing to understand the importance of these two. I’ll just tell you, from speaking with thousands and thousands of accredited investors over the years, the wealthy invest for passive income. I want to make one thing clear with that statement; notice I said, “INVEST for passive income.” Obviously, a lot of wealthy individuals are business owners, entrepreneurs, CEOs, you name it, they are active in earning income in different ways, but they invest passively, for the most part. Obviously, the exceptions to every rule – you have wealthy general partners, we’ll say, who are both active and passive in their investments.

But here’s the deal – you and I only have so much time in a day, so much time in a week, so much time in a year to be active on whatever it is we choose to be active on. Even if we’re the best CEO in the world, you may not want to put more than 80 hours a week in, because you’re going to burn yourself out. So how do you scale your income beyond your salary, let’s say, as being a CEO? You invest passively for passive income, and that way, money starts coming back to you, without you having to be active additionally outside of, we’ll call it, “work.” All that sums up to number one, understanding active versus passive income. Again, not financial advice, not technical definitions, just my take on it, sharing it with you to simplify the message.

Number two, the second rule is get financial education. I think we’re all very aware that our school system doesn’t do a great job at teaching us financial education. They might teach you how to check out a bank balance or balance a checkbook or something kind of crazy like that. I remember, in fact, in high school we did one exercise and one exercise only that even somewhat related to investing, and it was a terrible exercise. But all it was this, they gave us what’s called a paper trading account, which is a fake brokerage account. You just enter how much money you want in there, so we all started with whatever $10,000 or something. We each created a little sign-in. And then it tracked the real stock market day-to-day, but the money we were using was fake. The objective was, we started on a Monday morning, and every day we would do about 30 minutes on this exercise. The goal was by Friday, in this particular class, whoever generated the most money in their fake brokerage account, won. That’s a terrible strategy, because this is how a lot of people try to chase the shiny objects, they try to chase the highest yield, they try to get into the most speculative investments, with the highest risk profiles, without understanding that, which – we’re going to talk about risk here in a minute. Ultimately, it’s a buy low, sell high, and a get-rich-quick kind of mentality. It was the worst exercise ever. I didn’t realize that at the time but in hindsight, looking back, that was just terrible to try to teach people that that’s investing.

So when I say get financial education, most of us weren’t educated even in our own household about true professional investing. Some of us may have been grateful enough to get that kind of message, and we can’t rely on the school system either. So what I mean is listening to podcasts like this one, reading books, attending seminars, finding mentors… You have to be a go-getter, unfortunately. When I say unfortunately, most people aren’t go-getters, let’s be real. So it kind of requires that to be a professional investor. You cannot achieve professional investor status by just turning over your money to some money manager and saying, “Put me in the stock market, or whatever. I don’t care what it’s in, just do what you think is best.” That’s not a professional take on it; you need to do a little more homework, a little more due diligence, and take a little more ownership over your finances if you’re seeking to be a professional investor. Granted, not everybody is, not everybody would care to be, but if you are, and you’re listening to this episode, I’m just sharing what it takes to be a true professional investor.

I named several ways to get financial education; some are paid, some are unpaid, we’re all different. I know people that have paid hundreds of thousands of dollars to attend different conferences and mastermind groups; that’s effective for some of them. And I know people that have really, quite frankly, not spent much money at all – I would gather probably under $1,000 – to get financially educated, because they’re go-getters. They’ll go read 50 books from the library, they’ll go listen to podcasts that are free, and they’ll skim through YouTube to get content for free. So there are a lot of different ways to do it; you have to know a little bit about yourself, and everybody’s different as to which is most effective.

Circling quickly back to that story about me in high school and that exercise about day trading stocks basically is what we were doing… There was nothing taught about cash flow or passive income, which is the way that the true wealthy invest. To that point, that brings us to rule number three, which is invest for cash flow, or passive income, not for capital gains or potential appreciation. And I’ll explain why. The buy low sell high mentality is promoted and marketed worldwide, it’s not just in America. It’s this idea that I’ve talked about on the show many times, that you’re told by either an employer or by Wall Street or by your broker-dealer that, “Hey, just dump some money in your 401K and in your IRA, and then one day, it’s going to be all good down the road.” Well, it’s only going to be all good down the road if the markets just go up and up and up and up and up and up and up forever. And hopefully, when you pull the trigger to retire we don’t have a big market correction or something like that. So my point is, is it possible to flip a house today and make a profit, which is buy low sell high? Is it possible to buy a stock today at $10 a share and then it moves up to $15 in a relatively short timeframe? Absolutely, that’s possible. Absolutely. But you know, one of the biggest factors that help you achieve that goal is the market itself. If the housing market is booming like it is right now, there’s a better chance you’re going to make a profit, and the same thing can be said with stocks. If you’re getting in after the market bottoms and now we’re starting to see a recovery backup, you can virtually just throw darts at a board and make a profit over the next five years.

Break: [00:12:52] to [00:14:48]

Travis Watts: What I encourage you to think about is what about the 401K holders, what about the IRA holders, what about the buy low/sell high strategists when 2008 and 2009 came along? And by the way, we didn’t see a real recovery for many years. It was almost 2011-2012 before the market started making a rebound. So there were years of loss, and then years of settling, and then years of really just kind of flat returns, from ’08, ’09, ’10, and ’11. That’s a long time to sit on the sidelines. I’m not going to beat a dead horse, I’ve talked about the lost decade so many times between 2000 and 2009, where there was almost a 0% return, using a buy low and sell high mentality. So something to think about as an investor, again, being a professional investor, being a long-term investor, looking at the long-term horizon is what is the most stable and consistent and predictable way to grow your wealth? Because it’s great when you’re flipping houses in a booming market as I did in Colorado, along the front range in 2012, ’13, ’14, ’15, and ’16. I did great because the market did great. We are seeing, in some cases, double-digit annualized appreciation. Well, that certainly helps when you’re holding assets in an environment like that. But when the market corrects, as I said earlier, you might be buying at the top and then having to sell low if you can’t hold on to a cash-flowing property.

So we obviously know that a lot of people got crushed in the dot-com era in 2000, when everyone was buying publicly and privately into companies that had a potential to go up, but many ended up crashing and going to zero. That’s all because of the strategy that was being used. But have you ever considered what happened during the year 2000 or 2008-2009 to investors who were holding cashflow positive investments? Whether it be a company that had very little debt and was cashflow-positive, generating great revenue. Whether it was cashflow positive real estate; as your tenant’s paying it down, your occupancy stayed up. That is the key. The cash flow investors did great when the market went up, they do great when the market goes sideways, and not too many lost properties and did terrible when the market went down, as long as they held on to a cashflow-positive asset. That’s the point, you guys – markets can only go up down or sideways. So if the odds are two-thirds to three-thirds of the time, you’re going to be in the profit; that’s my exact point. So you don’t have to sit on the sidelines or take massive losses every decade or so.

Anybody who’s hoping or guessing that the price of something is going to be higher in the future is simply speculating. I know I’m going to take some heat for that comment, but truly consider that. I don’t know the future, you don’t know the future; as we’ve seen over and over on the news, talking heads and CNBC and all these different sources, everybody’s got an opinion every day. Every day, I could pull you an article that says the sky is falling and the market’s about to collapse, and I could pull you an article that says we’re about to start the next phase of the bull cycle, and things are going up from here.

Every single day we have differing opinions; that tells you that people are speculating. It’s the same thing as playing the roulette wheel and asking for people’s opinions. You’re always going to have someone that says, “I know it’s going to be red. I know it’s going to land on red.” Someone’s always going to say, “It’s going to land on black. I know it’s going to land on black.” Let’s accept that that is a form of speculation.

Now, with that being said, I’m not going to bash people who flip houses or trade stocks or do any buy low/sell high investing. I just want you to be aware that it’s really not as professional just to sit on something and ride the ups and downs and the volatility if you’re trying to build steady, consistent income. I’ll say it one other way, which is if you’re a cash flow or income investor, the price may be of secondary importance to the passive income if your focus is the passive income. Back to the Coca-Cola example – I don’t know what the share price of Coca-Cola is today, but just for example purposes, I’m going to say it’s $30 per share. Well, if they’re paying a consistent, steady dividend every quarter for the last 20, 30, 40, 50 years, whatever it’s been, does it matter, is the primary focus that the stock today’s 30 versus 31, versus 29, versus 28, if the dividend keeps getting paid out to you every single quarter, every single year, and you’re using that dividend to live on as part of your income? I would argue the price is secondary. If it happens to fall drastically, maybe you buy some more shares and dollar-cost average. I’m just saying for example purposes.

Same thing with real estate – if you paid 300,000 for a single-family home that you’re renting out for $2,500 a month cash flow, does it matter if the market softens a little and now the estimated value of your real estate is 275,000? If your tenant continues paying $2,500 per month and they’re locked into a long-term lease, I would argue that it’s really not that important, unless you are looking to sell the property, which is back to buy low and sell high strategy, which I don’t use, and a lot of wealthy professional investors do not use either.

Okay, moving on to rule number four. The final rule is to understand risk. Something that is not talked about nearly enough in the industry of investing. But I want to ask you this quick question. Is it more or less risky to rely on one income source or 40 diversified income sources? Well, to me that answer is pretty obvious, but I guess some people have a different take on it. In fact, I want to share one of those stories with you. Several years ago, I was talking to my brother-in-law about investing, just kind of feeling out what kind of investing he does, or if he invests… And it turns out he does not invest; and this was his reason. He told me very specifically that it’s too risky to invest when you have kids. What he was really trying to explain or articulate is that he thought it was risky to take money away from providing for his family to invest, I’m guessing in a speculative sense, because he couldn’t afford to lose that money. Granted, there is some merit to that. Unfortunately, as I said, he’s probably thinking about speculative investing, like in the crypto space or something like that, and not so much in stabilized, cash-flowing real estate. Of course, you never want to invest any money that you can’t afford to lose.

So I did agree with him in many ways, but then I got to thinking about it… But on the flip side of that, he has one income source, and it’s his job, and it’s a high-paying job. I thought, what would your family do or what would he do if he lost his job and his income went to zero? Or what if his company said, “Hey, budget cuts and salary cuts. Sorry, but you’re taking a 30% cut.” Well, this stuff happens, as we all know. He would have no backup income. Hopefully, he would have some savings and some emergency fund, but his income would go from 100% to potentially 0% overnight, and it’s something that’s not necessarily in his control.

So on that topic and to that point, this is why it took me almost six years to realize the real risk in investing in single-family homes the way I was primarily investing in single-family homes, as a buy-and-hold investor. I thought, one, if I had a tenant move out, which I did on the regular, my income didn’t just go from 100% to zero, it went from 100% cashflow-positive to immediate cashflow-negative. In other words, I didn’t just lose my positive cash flow, we’ll call it $300 a month for example purposes on a property, but when someone moved out, whether it was planned or unplanned, I went immediately in the whole negative, because I still had a mortgage payment, property tax, insurance, HOAs in many cases, and I had to pay those bills without having any income roll in to cover it.

So consider this as a quick math example. As you all know, I’m not very good at math, but I’m just going to hit some simple, basic numbers. If I had a single-family property, and it was $300 a month cashflow-positive. That means that the rent comes in, I cover all my expenses, and at the end of the day, I was making $300 per month in positive cashflow. Let’s say one of my renters or the renter on that particular property moved out. And it was all expected, it was that they did a 12-month lease, and at the end, they decided they weren’t going to renew; they were going to go buy their own house or something like that.

Let’s say it took me 30 days or roughly one month to turn the property around. They have to move out, I have to get it cleaned, I have to relist it, I have to interview people, and then the new renters want a one or two-week extension until they can move it. Let’s just say it was one month to get it covered. Some example expenses would be, I might have a $1,500 a month mortgage payment on the property. I might have a $200 a month HOA fee to pay, I might have $250 in property tax. I might have a $100 per month insurance policy that I have to pay, and it might take me $200 to clean the carpets and clean the place up for the next renter.

When you tag all of that together, it’s over $2,000 of an expense. When you look at a property, a single-family home that’s $300 a month cash flow positive, you’ve got to remember that in an event like that, even an expected event that happens every year, could knock out eight months of your cash flow, the better part of a year. And that’s just turning the unit over, not to mention all the maintenance nightmares that I had to deal with, from leaking roofs, to shoddy plumbing, to having to paint properties, to landscaping messed up, to special assessments with HOAs… When you factor in all the risk points of going cashflow-negative, the maintenance, and the unexpected things, it’s awfully hard, in my personal opinion and my personal experience to make good, solid, consistent money with single-family homes. It’s what prompted me to shift after six years of doing all that kind of stuff into investing in stabilized, cash-flowing, multifamily, primarily value-add business plan syndications.

I’m not saying that everybody should do what I did; not saying everyone’s experience was what my experience was. I’m just saying as a fourth point, to understand the risk of what you’re investing in and weigh that out against the potential reward that you’re looking at getting in that particular investment.

I digressed from that story… I hope that you guys found this episode useful. Again, I will recap for you the four “rules” for professional investors. It’s understanding active versus passive income, it’s getting financial education, whether it’s paid or unpaid. You’re on your own to self-educate, unfortunately, in most cases. Number three is investing for cashflow, not capital gains, or hoping that markets always go up, up, up, and away. Number four is understanding risk.

Thank you so much for tuning in to today’s episode on The Actively Passive Investing Show. I’m your host, Travis Watts. Don’t forget to like and subscribe. Always happy to be a resource to anybody, reach out anytime. We will see you in the next episode.

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