Passive income seems like such an awesome idea (and it can be), but it's also the concept behind every get-rich-quick post on Instagram and Facebook. How can it be both?
Part of the issue is that it’s a concept often referred to in the singular, as if all sources of passive income are the same. But they are not, so let’s dive in to determine what type of passive income should be the ones you focus on.
Firstly, passive income is not free nor easy nor in most cases quick. It’s an investment in time and money and should be treated like any other investment. The relative rewards must be considered, which includes a systematic assessment of the risk vs. the level of investment and the opportunity cost of each.
(Creating a course, Building an app, Starting a Youtube, TikTok or Instagram account, Selling an e-book, etc.)
The beauty of selling digital content or services online is that after the cost of creation, the investment does not increase with each sale. That means, digital content can be incredibly profitable if you scale.
But to scale requires 2 things — a great product people want to buy and demand. It's a very competitive market out there and creating demand takes a lot of time and money.
While we might all aspire to be the next David Dobrik or Toddy Smith, the chances of that happening are incredibly low.
So while the potential return is high, the probability of you achieving it and the risk of failure plus the investment in time and energy is also very high. Therefore, this path should be viewed as a longshot/big-upside path to passive income — it’s not a great strategy to rely on unless you have some genuinely special skills or relevant experience, in which case by all means try (just don’t rely on it and don’t expect to get rich quick!).
(Laundromat, Amazon, Vending, ATM machine, etc.)
As with any business, nothing is free and there are few shortcuts. Running a laundromat does not sound like easy work or much fun, and the profitability of the venture is highly dependent on being able to affordably acquire such a business and run it successfully. Amazon is the most competitive shop on the planet and not cheap as a channel for merchants, so while one could set up an Amazon shop quickly and easily, the time and energy it will take to be successful is a real investment and the probability of making a passive-income fortune that way is quite low.
More businesses fail than succeed, and the easier they are to create, the higher the proportion of failures.
(Airbnb, House rental, Car rental, etc.)
Leveraging existing assets is a great way to earn additional income, but some caution is required. Not every AirBnB location is going to drive significant volume all the time (especially during Covid), and the costs of maintaining and running an AirBnB can be deceptively high.
When it comes to renting out a driveway space, the overhead is basically non-existent, but the platform itself takes a sizable portion of the profits. So, this can be a good way to make a little money, but it certainly isn’t a path to true wealth.
Rental properties have for many years been an effective way to passively earn income, but the barriers to entry are high. You need to be able to borrow enough to buy the house in the first place, which takes a large nest egg, great credit, and a willingness to take on huge debt.
Renting out assets is a very mixed bag, but the biggest wins only come when you have sufficient capital to buy assets like a rental property. Barriers are therefore high — it’s a great tool to expand wealth but a hard one with which to build it. The greatest returns will come as the property itself increases in value over the long term.
(Savings accounts, Dividends, and Investing)
Putting money in a Savings account is a slow death. Returns on even the highest paying accounts have rarely surpassed inflation, meaning your cash deposits are slowly losing value. During Covid, with interest rates at historical lows, no one is making meaningful returns on cash deposits, but even over the last 40 years, the best savings rates have averaged little over 2%. That means, the probability of making tiny profits is high, but you need a vast amount of cash to generate anything close to a meaningful income.
Dividends are an example of a true passive source of income. Buy the stock or funds, and sit back. Dividends for the S&P 500 average around 2% over the last 10 years — the equivalent of the top-of-the-line savings accounts. And reinvesting those dividends allows you to benefit from compounding interest, one of the most powerful forces in economics. Risks are low and barriers are low, but in order to be delivering a meaningful amount of passive income will mean investing a substantial amount. This is a slow, safe way to build wealth, but is not a pathway to getting rich quick.
The best strategy for maximizing your passive income is Investing for the long term. If you had invested $200 a month for the last 40 years into the S&P 500, you would be the proud owner of a portfolio worth over $2.5m today. The combination of capital growth, reinvested dividends and compound growth means even relatively small frequent contributions can, over time, add up. By dollar cost averaging — or spreading out the investment contributions over time — you manage the risk of market timing, lowering the variability of buying too high or too low. It’s exciting to think you’ll beat the market by day trading, but that kind of high-risk/high-reward activity is not the way to sustainably grow wealth.
Investing for the long term is low risk, high probability, and high reward. And the barrier-to-entry is low.
All you need is to start early, be consistent, and let compound growth do the rest.
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