Individual investors typically focus on maximizing Return On Equity above all else. More sophisticated investors understand that returns should be measured after costs and fees, and on a risk-adjusted basis.

In this post, we will talk about another important concept for the investment process of the individual investor: Return On Time Invested. This concept measures investment returns vs. the time required to achieve those investment returns. For individual investors, especially those with limited time and resources, understanding the importance of return on time invested can be a game-changer.

Calculating Return On Time Invested

You know the feeling. You meet someone at a party or networking event who brags about their investment performance. While your broadly diversified ETF portfolio achieved a paltry 9% return, their savvy stock picks resulted in a 12% return! Impressive, you would think. However, the comparison between this person’s highly concentrated stock-picking portfolio and your passive ETF portfolio is not a fair one, for two reasons.

Firstly, you should compare risk-adjusted returns. By definition, a highly concentrated stock picking portfolio will have higher idiosyncratic risk than a diversified ETF-based portfolio. The concentrated portfolio’s performance is closely tied to the performance of its individual positions. If the CEO of one of the stock picks unexpectedly steps down, the portfolio performance will suffer significantly. This is not the case for the diversified ETF portfolio. In addition, if the portfolio is invested in higher-beta stocks, which is quite likely given the degree of outperformance, the systemic risk (beta) of the portfolio is also higher.

Secondly, as explained further in this article, you should compare Returns On Time Invested. If your friend achieves a return of 12% p.a. by spending 10 hours per week analyzing stocks, did he really outperform your passive return of 9%? Assume you both invested €50,000. You achieved a return of €4,500 while he achieved a return of €6,000. His outperformance of €1,500 was the result of a time investment of 10 hours per week, or 520 hours per year. This implies an hourly rate of €2.88/hour. Worth your time? Probably not.

A superior Return On Time Invested can be defined as an active return for which the implied hourly rate is higher than your professional hourly rate (after-tax). After all, if it is lower, as in the example above, you have not really achieved outperformance – you have just given yourself a low-paying job.

Why does this matter? Isn’t higher return all what matters, no matter how much time you invest in it? No, because you would be financially better off by investing passively, while working an additional 10 hours per week. You could work overtime (if paid), or get a job or side-hustle which pays a similar rate as your day-job. Let’s say our active investor, who realized an excess return of €1,500 due to active investing, earns €15/hour after tax. If he were to work an additional 10 hours per week, he would earn an additional €7,800. Clearly, it would be better for the active investor to work on the side, earn €7,800, and invest the proceeds passively. His passive investment return, €4,500, and the additional earnings of €7,800 sum to €12,300, far exceeding the proceeds of active investing, €6,000.

Passive Investing

This simplified calculation highlights how challenging it is for individual investors to really outperform the market with active investing. There are so many obstacles to overcome: your active strategy has to outperform the passive strategy after fees, costs and taxes, it has to provide a superior risk-adjusted return, and it has to provide a superior Return On Time Invested.

Active investing may be an appropriate choice for wealthy individuals, for whom an extra 1% return results in a significant difference in euros. For people with moderate wealth, the excess return potential of active investing is not worth the required time investment. In this case, passive investing is a more appropriate choice to build wealth. Instead of spending hours analyzing individual stocks, passive investors can achieve the broad market return with minimal effort. The time saved through passive investing can​ be redirected towards making more money,​ оr simply spending quality time with loved ones.

Return On Time Invested measures the opportunity cost of time spent on investment research. If the expected excess return does not exceed the opportunity cost of time invested, it does not make sense to pursue the active investment strategy. Return On Time Invested recognizes that time​ іs​ a finite resource which carries an opportunity cost. Embracing it is likely to lead to better financial outcomes for the large majority of individual investors.