One and a half years ago I did a post about Labour vs. Investment Income and Mike did a post about Do You Really Earn Your Investment Income? The point of both of our posts was that there is an expected investment return (ROI) that an investor can’t really take credit for. If you match the average market return, have you proven your skill as an investor, or have you just been in the pool when the water level went up for everyone? In my post I focused more on whether you want to improving your ROI or on just increasing your income, depending on how much you have to invest.
Beyond these considerations, I also think there are a number of investments that blend labour and investment. Flipping real estate is a prime example. You can’t buy the run down property without some cash to invest, but then you get the (sometimes) crazy returns because you work 80 hour work weeks fixing the place up. Someone without many marketable skills might be best served starting their own company that they run (such as a convenience store or a franchise). This, in a sense, lets them “buy” a better exchange rate on their labour then they might be able to get from a job by putting capital in with their labour.
In situations like this, it becomes very easy to fool ourselves about how well (or badly) we’re doing. As Mike points out in his post, if someone was day-trading full time, they have to be making MORE money than they would get from an index-fund and a full time job to really justify it (which I think would be highly unlikely). The day trader who looks at his account and is proud of the money he’s made is ignoring the opportunity cost of his lost salary.
Flippers are notorious for this. Even when you get them to be honest about their actual costs (often they like to omit transactions costs from their profit statement), you’ll NEVER get them to even account for the amount of time they put into repairs. Get them to include this and the time they spent setting up that deal, investigating deals that didn’t work out, marketing the repaired property, meetings with partners and completing the purchase and sale transactions and you’ve got a proper picture of their real investment INCLUDING their time (which will let them accurately calculate their profit).
Even people who buy-and-hold real estate long term are guilty of this. If you aren’t hiring a property management company (and I’d personally be very cautious before you do this), you have to account for doing this work yourself. The best way to do this is to pretend to “pay” yourself what a PM company would charge, and add this to your cost. John T. Reed estimates that self-managed real estate takes 3.6-4.6 hours / unit / month to manage (remember although some months you don’t do anything, you’ll have the times where Murphy strikes and you keep having to go back to a unit to do one thing after another). An index fund or GIC takes FAR less time and this has to be factored in if you want to honestly compare the investments.
One approach to honestly compare such investments is, as already mentioned, determine what others would charge for this and add it to your costs. For real estate this would be what a property management firm or contract would charge, while for a self-run business it would be what you’d pay a clerk at your convinience store or a manager at your Subway® franchise. If you’re unhappy working for such a low wage, then you’d be best served to hire someone to do that work for you, and get a job earning the higher wage you think you can make. Don’t fool yourself into lumping the franchise profits into your salary and think of yourself as the highest paid convenience store clerk in the world.
Similarly, once you have an honest appraisal of the ROI from your venture, if it no longer looks lucrative with your time factored in, dump it and put your money where the ROI (based on your time and money) *IS* reasonable.