Active investment management is often ridiculed for poor returns compared to passive indexing (not often enough judging by its continued popularity). The few funds that do consistently outperform the closest index are difficult to find before enough investors flood in to drag down their returns. Based on this knowledge, I concluded a while ago that it would be very difficult to get investment returns significantly higher than the long-run average real return of stable stock markets such as those in the US, Canada, and western Europe.

This can certainly form the basis of a good investment plan and there’s nothing wrong with “only” getting the market average. However, reading The Snowball gave me another perspective on this. While choosing someone else to actively manage your money often comes at a high cost, there are a lot of potential investments that can have higher rates of return but require your direct involvement. The book includes many stories about how Warren Buffet used his money early on to start small (and often temporary) businesses that grew his capital significantly.

This definitely wouldn’t be the right thing for everyone to do. If you don’t want to spend a lot of time managing an investment or apply specialized knowledge that you already have, the easiest thing to do is still to buy index funds. Since I don’t have a job and I’m free to allocate my time any way I see fit this idea is particularly interesting. By setting aside some money for investments that I’m directly involved in I may be able to get higher rates of return than I would by investing in public companies. I’m interested in business in general, so having to spend time managing an investment wouldn’t feel like a waste of time. It might even help me learn more by exposing me to new challenges.

One simple example of a direct investment is real estate. If you find a property that has positive cashflow from the start the combination of those profits, the mortgage principal payments included in the rent, and the property value appreciation may give you a rate of return well above the average expected from stocks. Another example might be buying a small business that’s currently profitable.

Doing this successfully will require a big change in my perspective. So far I’ve pretty much always done things myself except for the cheapest services that would never be worth my time. Getting things done by investing money instead of time requires a different approach, but it seems to have a lot more potential.

A danger in this type of investment is that the time required actually makes the rate of return much worse. If you don’t account for this your time input may add hidden costs that turn it into a bad investment. If the income generated doesn’t depend directly on the time you put in there’s the potential for good returns including the cost of your time; there may be periods where you have to put in time that would earn you more money at your current hourly rate, and other times when you just have to check in now and then to see that everything is ok.

Another type of active investment is what Buffet later turned to: detailed analysis of the stock markets to find undervalued stocks and buy them. While this can also have higher returns if you put in the time to get a better understanding of the market than most investors it’s not something that interests me much. It’s also likely to be much harder now in developed markets than it was in the 40s, 50s, and 60s (although there are still times when the market presents obvious opportunities to those who can see them).

I’ve just recently started to think this way, so it will take a while to adjust fully and see the opportunities to increase my rate of return. Meanwhile I plan to continue investing in stocks, and start building up an account that can be used to fund active investments.

Do you look for ways to get a higher return than index funds? What’s your preferred method?