These days it seems that everyone is looking for set it and forget it ways to make income. The problem is that you either need 1) valuable information that is static or 2) a grip of cash. Every other income stream in the world is not static in the least bit. If you have to constantly update the item (this blog is a great example) then it is no longer passive as it requires time.
Our definition of passive income is this:
“Income that is generated without the use of your time”
Other forms of income are at best… location independent income.
This is the type of business everyone dreams of. A set it and forget it business that generates loads of money without being monitored.
1) Static Website: In the older days of online sales (before they created video sales pitches and continuity programs), there would be a simple sales page followed by a product offering… You have seen these before.
“Do YOU want the WOMAN of your DREAMS?”
Followed by a lot of emergency type language (red text of course) and a “Click to Buy” and check out at the bottom.
These are always accompanied by testimonials as well. The consumer reads the entire sales pitch (usually a good 5-10 pages long) and then makes his purchase decision. This is 100% passive as you have a product that is simply sitting there with a sales pitch. If there is no need to update the product, then it is simply passive income.
2) Recurring Service: The second form of primarily static information would be a service. For those that work on Wall Street… a great example would be FactSet or Capital IQ.
Before you jump in and say “but these products are updated!” the point is that the revenue is recurring. If we really want to get nitty gritty then we can simply use software as an example. You pay for the use of a specific program such as Microsoft and then you bill the client on a yearly basis for 1) services (not passive) and 2) use of the software (passive) since the software would never be updated.
Naturally, the software is updated to keep up with competition, but you should get the idea. It is simply access to a value additive system that does not need to be updated in a meaningful way.
3) Location Independent Income: While this is not passive income, we will add it for clarification. Location independent income can be summarized as follows – “A task you can do on the internet”. That is all a person really means by “location independent income”. Since you are making your money through the internet as a medium of communication this can include 1) online company, 2) blogging and 3) convincing your employer to allow remote access.
Overall, we believe everyone should at least attempt to create location independent income. Ideally, you can create a massive income from a static website, but the vast majority will end up creating some location independent income. If you are able to create large static income, we commend you and you have accomplished a difficult task.
This is the second form of passive income. Having a grip of cash. In finance, when you interview you’re asked for the most important financial statement. Generally speaking the best answer is “Cash Flow Statement” because… Cash is King. Managing cash flows is extremely important and a large sum of cash can help breed… More cash. With the importance of a high savings number let’s take a look at multiple investment streams from a risk tolerance perspective. We will start with the highest risk, highest capital growth and work down to lowest risk lowest capital growth.
1) Qualified Dividends: This is the most common source of dividend income. Simply put, if you own the S&P 500 you pick up a ~2% dividend (as of this posting) on an annual basis. This means that if you own $100K of S&P 500, you will also receive $2,000 by the end of the year. For most individuals the $2,000 will be taxed at 15%, however if you have a personal income of ~$400K or ~$450K as a household, then you will be taxed at 20%. We are not going to go into a long winded post discussing taxes and their merits; instead this is simply how the system works.
The Rub: Post tax yield of low single digits (2-4%) with more hope of equity upside. The higher the dividend the less expected equity upside on the stock (generally).
2) Unqualified Dividends (REITS, MLPS and Special One Time Dividends): What is the difference between a qualified and an unqualified dividend? The unqualified dividend is taxed as regular income. That is the simple difference. Today, REITs pay a high dividend, however you should be cognizant that the income you receive may be taxed up to 35% and beyond if you are in a higher income tax bracket
The Rub: Post tax yield of mid single digits (4-7%) with a bit less hope for equity upside.
3) Junk Bonds: We won’t go through a long winded explanation of how bonds are safer than equity. However. The simple explanation is that you’re first in-line in case of bankruptcy and you’re entitled to income “above the line” of the income statement (ie you represent the interest payment line. Junk bonds pay high yields however… This comes with additional risk… Tread carefully when seeing high single digit yields.
The Rub: Strong yield of mid single (5-7%) with very minimal hope for upside, unless the Company sees large changes to is investment grade (in which they will likely buy back the bonds and reissue new ones at a lower rate).
4) Investment Grade Bonds: These are significantly less risky (unless you owned some of those collateralized debt obligations back in 2008) but essentially you’ll pick up a nice yield of ~3-5% and you can sit back, relax and collect those monthly coupons. Of course these bonds still have risk, but the debt ratings for these securities are quite tight.
The Rub: Medium Yield at 4% and we are approaching minimal risk territory.
5) Government Bonds: There are many types of bonds, 30 year bonds, 10 year bonds, 5 year bonds, 1 year bonds… we could go on and on. In addition to these durations, you also have different tax structures with municipal bonds, treasuries, treasury inflation protected securities (TIPS) etc. We could do a 70 page post on bonds and it still wouldn’t cover everything. Instead think of these bonds as “risk free”. Please note we are putting risk free in quotes because literally nothing in life is 100% risk free. If the government defaults, you will not get paid. However. We find this highly unlikely as we are not part of the doom and gloom, losing in life camp.
The Rub: Practically risk free and will likely outpace inflation by just a hair (excluding TIPS of course)
6) Certificate of Deposits: These are FDIC backed time deposit investments. They are essentially risk free and offer low rates. This is a poor tool for wealth creation, however a staggered long-term CD will allow you to keep pace with inflation (hopefully).
The Rub: Essentially a way to hedge inflation.
Securitizing Your Future
The big difference. How do you balance risk (higher risk at the stock level) and time (your age) to achieve the best balance for the future? In our view, the best balance is actually a bit less dependent on age and is more dependent on your life style and net savings.
Guideline according to us:
1) If you have less than 5x your annual spending in savings. You should have it primarily in stocks. Call it 90% stocks and 10% cash in case there is an emergency
2) As soon as you reach 5-8x in annual spending in savings you can make a shift. Here we recommend 70% exposure to stocks, 20% exposure to bonds and still a 10% cash position.
3) As soon as you reach 10-15x of annual spending in savings, you are now near “retirement” in terms of ability to live entirely off of cash flow. Here you can have a mix with 40% stocks, 30% bonds, 20% low risk government bonds and CDs, 10% cash.
4) As soon as you reach 15-25x of annual spending in savings. You are now free. If you can simply keep this cash in a mix of baskets of goods, you will unlikely have any money issues in your future. You can either take risk off the table (practically all of it) by leaving it entirely in low risk bonds and government backed securities. Or you can continue to grow your wealth (if you are young).
Please note that we assume you are near retirement at 10-15x annual income as savings… because many people will pick up a hobby or job they enjoy for minimal income. No need to retire and sit on the beach for the rest of your life.
In our view, it is best to create a mixed bag as fast as possible. You work and have a solid career that pays well. You can create a small business on the side and create some location independent or even static business income. You then save cash by keeping your lifestyle in check and build up a nice nest egg that gives you momentum. You will see your portfolio gain momentum once you have ~ 8x annual spending in savings/investments.
At that point it is up to you. If you’re young we suggest keeping a bit more in the stock market and if you’re older then you dial back the risk and look at bonds/deposits.
Updated for 2017 and beyond.