There are three ways to generate passive income; start a business, invest or speculate. The key word in that sentence is passive. Passive means you can generate economic benefits without the requirement of your personal exertion. Since it doesn’t require personal exertion, it frees up your time to spend it on activities or with the people you love.
Each of these three options have merit. But the important thing to note is that not all three will suit everyone. This point is very important to appreciate, and could save you a lot of time, stress and money!
A quick bit of theory first; Hedgehog Concept
Legendary author and prolific researcher, Jim Collins formulated a concept called the “Hedgehog Concept”. The Hedgehog Concept was based on the famous essay by Isaiah Berlin in which he refers to an ancient Greek story: “The fox knows many things, but the hedgehog knows one big thing.”
It was Collins’ thesis that successful companies are laser-focused on the Hedgehog Concept, which is the intersection of 3 important considerations or questions (i.e. the orange portion in the illustration below):
- what you are deeply passionate about,
- what you can be the best in the world at, and
- what best drives your economic or resource engine.
Successful companies focus on delivering products or services that they can be the best at and ignore all other opportunities.
(By the way, Jim Collins’ book, Good to Great is one of the best business books I have read.)
Let me share a quick story about me
Before I relate this theory to personal investment, let me share a story with you.
I have some friends that are successful property developers and make substantial six-figure profits. In the past, I have considered whether I should get involved in property development too, especially since I have the property, finance and taxation knowledge. However, many years ago, I decided to focus on my Hedgehog. Property development just isn’t for me.
Property developing takes a lot of time. So, I could either spend my time on developing property with the aim of generating a once-off profit. Alternatively, I could spend that time thinking about and helping my clients build wealth. Just one idea that helps a client creates a lot of value for them and me. That client will continue to do business with my firm and will likely refer their friends. And that will generate long term value for both of us.
I am deeply passionate about delivering the best independent financial advice. I am good at the work I do. And accumulating a number of happy ongoing clients generates stable economic returns. This is my Hedgehog and when I stick to it, my personal wealth grows. The reverse is true when I have deviated (which I did before I learnt this lesson).
One of my mentors, who has operated a successful business for more than 50 years and built significant personal wealth, advised me; “Every time I’ve done something outside of my core business, it has cost me time and money.”
Medico mortgage default rates are low if they stick to what they know
The big 4 banks all have special divisions that target doctors (and have for many years) because it is widely accepted that mortgage default rates are substantially lower than the average. This stands to reason given few doctors are ever unemployed and their income is very stable and typically higher than the average.
This is true when lending to a doctor for home or investment purposes. However, statistics demonstrate that when a doctor borrows for another purpose e.g. property development or unrelated business, default rates skyrocket. Most doctors are smart, hard-working people. But that doesn’t necessarily translate to them also being successful business owners. Statistics would overwhelmingly indicate that doctors should stick to their day job.
My client Simon…
Simon has been (mortgage broking service) client for over 10 years (this is not his real name of course). Over this period, he has tried to find many shortcuts to wealth. This has included investing in different property types and locations, which might have been sexy at the time but lacked fundamentals. He has also dabbled in various businesses. None of these activities have created a lot of wealth and some have been a disaster.
Simon’s has earned an above average income for a long time and doesn’t over-spend (lives relatively frugally).
Simon would be in a substantially better financial position today if he stuck to an evidence-based strategy and quite frankly, not listened to his own advice or ideas.
Mistakes often compound. Making a bad investment decision that causes financial loss often tempts people to brainstorm ideas with the sole aim of mitigating any financial losses. These ideas are invariably aimed in the pursuit of short-term profit (which is at the cost of long-term value). In effect, one bad decision is often followed by another.
Do you have the ability and passion to become an investment expert?
The proverb “A little knowledge is a dangerous thing” needs to be rewritten for investing. The proverb should be “Anything short of complete knowledge is a dangerous thing”.
Some of my clients are quite financially astute. They understand and know most things – they are just missing the last 5-10% of knowledge or experience. But that last 5-10% is usually critical. You only have to be a little bit wrong to be completely wrong.
The fact is, that some people will never become great investors. Some people will never be successful entrepreneurs. But that’s okay. You must find what you are good at and delegate all other important things.
The Hedgehog Concept applies perfectly well to personal investing. You must ask yourself two questions:
- Can you be the best in the world at formulating and implementing Australian-based investments; and
- Are you deeply passionate about investing – passion is more than just an interest?
If you can honestly answer yes to both of those questions, then it’s likely it is in your best interest that you make your own investment decisions.
However, if your answer is ‘no’ to either or both questions, then you are better off sticking to your day job and paying for (and following) high quality financial advice. When it comes to building wealth, often the slow and boring path is the most successful one in the long run.