The truth about passive income and how to approach the five relevant categories of wealth generation.
Stephane Perrin takes a look at the most alluring form of income generation and how you can to build it into your financial planning.
Interest in passive income has been on the rise for many years. Just take a look at this Google Trends graph to see that it’s never before been higher in terms of search.
So why are more people than ever investigating this irresistible form of income?
Rising living costs, the emergence of flexible employment, the vast level of online opportunities could all be contributing factors. Or perhaps it’s that people’s attitudes toward work and wealth creation are changing. The global workforce is wising up to the fact that traditional active income (where you give up your time and are paid for your work) or profit income (where you sell products or services for more than they cost to make) are no longer the only paths to financial independence.
This article takes a look at the concepts behind passive income, and the considerations to make when building it into your financial planning. While there will be examples of passive income streams, it won’t contain guides on how to set them up. Google is your friend for that!
Passive income in a nutshell
So what is passive income? It is income that requires little or no effort to earn and maintain. While a level of work is involved to set-up or maintain passive income, the revenue is no longer directly tied to active work.
For example, earning income from a rental property requires initial work to generate money to buy the property in the first place. And once rented, property management is still needed.
So typical passive income sources are front-loaded with active work, with income following over time once most of the work is done.
Before progressing, it’s worth pointing out that the get-rich-quick brigade has jumped on the passive income bandwagon recently. The internet is awash with schemes that promise you’ll be sitting on a beach drinking cocktails watching your bank balance increase in no time at all.
The reality is that initial capital sums or hard work will be needed first, and you will certainly need to allocate resources to manage these income streams.
How to approach passive income
There are primary considerations need to be made when devising a passive income strategy can be broken down into three categories:
- Initial outlay — either time or capital you have available to get a passive income venture up and running.
- Management resources — Amount of time you’re willing to allocate to the running of the passive income stream.
- Risk appetite — your tolerance to high risk and reward.
Unfortunately, you’re not going to be able to have the best of all of the above. There simply doesn’t exist an income stream that requires little outlay, no management and has no risk that provides a massive payout. Something will have to give!
Your goal
Once you’ve taken stock of the considerations above, the overarching element is your financial goal. We’d all like to generate millions in passive income but in reality that’s not going to happen, so be realistic about what you’re trying to achieve.
The reasons for wanting passive income will be personal to you. Perhaps you’re looking to generate enough additional income to build a deposit for a first home, or you want to phase out reliance on active income from your life gradually. But the core principle of passive income is that it stops you trading your time for money, or at least reduces this burden.
So work out how much you’d need to achieve these goals and then work backwards from them.
Types of passive income
Listed below are five types of passive income with widely varying characteristics. Some require a large amount of initial capital or require high levels of management and others carry a great deal of risk. As such, some will be more suitable or available to you than others.
However, it’s important to note that it’s not a matter of picking one route and pursuing that. It makes sense to spread your efforts across several categories. For example, perhaps a small allocation of a higher risk strategy can be justified if you have a primary focus on steady passive income generation.
- Interest Income — the most obvious and easiest to understand method of passive income. Yearly gains aren’t going to move mountains until the capital sum is considerably built up. But with a little patience, this will come sooner than you think with the power of compound interest. Also in this category is lending which is essentially the same; it’s the service you are providing to the bank!
- Dividend Income — investing in stocks and shares may not provide an interest return (although there is a potential capital gain, which we’ll discuss below). Still, shareholders often benefit from the distribution of dividends. The dividend payout will be dependent on both the success of the company and the inclination of its board. With the right selection, the payout can dwarf income compared to passive income derived from interest.
- Rental Income — the most prominent and usual form of rental income is property rental. Technically this could include possessions such as vehicles or equipment, however typically this tends to fall into profit income within a business arrangement. With property rental income the returns are high, but management is involved. The required initial outlay to buy a property may render this form of passive income outside the immediate realm of someone just turning to alternative wealth generation — unless you want to consider renting out a room in your current home.
- Capital Gains — This is the income realised when selling possessions that have increased in value. Dividend and rental income are great, but the underlying asset classes can also provide value in the form for capital gain. However there is risk involved. Market values can go up as well as down. Housing and stock market crashes have hit investors hard. Furthermore, depending on which country you reside, be mindful of potentially heavy-hitting capital gains tax.
- Royalty and Commission Income — probably the most alluring of the passive income streams as it’s quite easy to set up a side hustle to run alongside your regular job. It’s also perhaps the most accessible given that financial outlays are low. However, this causes problems. Due to the low barrier to entry, you could find yourself competing against a whole economy of others hoping to write the next trending article on Medium, compose a chart-topping track, upload the next viral YouTube video or create a killer mobile app. Your time may be free, but there is a risk that you may not get the payout you desire. But don’t be dissuaded. If you can put aside some time to hone your craft and find a suitable niche, content you create could keep paying income for years.
With all of the solutions above, you will not be able to live off the income straight away. Still, as long as you exercise a little patience, you will be making a positive step towards building your net worth and creating income streams that take you towards your financial goals.
The Automata solution
Passive income and wealth generation is an obsession of ours at Automata. We believe that the banks have long given customers a rough deal and interest rates offered on savings accounts very rarely do much more than cover consumers’ deposit from inflation. Our platform is designed to help you put your money to work for you more efficiently. From the forms of passive income listed above, the Automata platform offers a hybrid form of interest and capital income generation through automated investment and exposure to a variety of currencies, stocks and shares, commodities and cryptocurrencies. If you would like to find out more, visit our website or drop us a line.
Written by Stephane Perrin, CBDO at Automata. Connect with him on LinkedIn here.
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