A well-constructed portfolio of income generating investments is one of the most reliable ways of becoming financially independent. The fastest way to do this is by saving as much as possible. But, investing in the right types of assets is also necessary. Income producing investments must produce safe and reliable cash flow. And, ideally, their yields should increase over time too. In this post we discuss ways to make passive income along with the advantages and disadvantages of each.
- What is passive income?
- What is income investing?
- How to define your personal investment goals
- 10 Passive ideas to build a passive income investment portfolio
- Protecting your capital
What is passive income?
Passive income is cash flow that you receive from an asset, and that requires very little day to day effort. Interest paying savings accounts and rental properties are good examples of passive income investments. If you can save enough and make some savvy investment choices, you can eventually replace a salary with the income from your investments. If you can reach this goal, you will not be dependent on a job to be financially secure.
You will also have the freedom to spend all of your time on whatever you want for the rest of your life. This is the ultimate goal of most income investing plans. Passive income investing allows you to leverage your savings to eventually generate a regular income.
What is income investing?
There are two ways to create a portfolio capable of producing enough income to be financially independent. Firstly, you must save as much as you possibly can. The larger your asset base, the more income it can generate. Secondly, you need to maximise the annual yield, without taking on too much risk. Income investing is all about finding the right types of investments and diversifying to spread the risk and optimise the risk / reward profile of the portfolio.
How to define your personal investment goals
Before building a portfolio of passive income investments, you should set out your goals. Ultimately you will probably be targeting a certain amount of annual income. This will depend on where you live and the standard of living you hope to achieve. Whether or not you own your house and apartment will also affect the income you require. You can use your current income as a starting point. Then, you should add whatever you believe you will need in order to have the level of financial freedom and lifestyle you are aiming toward.
Obviously, inflation needs to be considered too. History suggests that if you plan for inflation of 4%, you will probably be building in a margin of safety. However, if the inflation outlook changes dramatically, you may need to revaluate. If you live in a country prone to higher inflation, you may want to factor in a higher rate.
You should now have a rough idea of the sort of your target yield in dollar terms. This will be a moving target – the longer it takes to reach your goal, the higher your cash flow requirement will be. When you start investing, you will get an idea of the likely percentage yield you will be earning. This will give you an idea of the capital you will need to accumulate. Your income investing plan will also need to account for the amount of liquidity you will need, and any cash you will need for emergencies. An emergency fund can still generate income, but the yield will be lower.
10 Ideas for passive income investments
Once you have some investment goals you can begin saving and building a portfolio of passive income investments. The following are ten types of passive income investments to consider.
- Dividend Stocks
- Robo Investing
- Direct Real Estate
- P2P Lending
- Four percent rule
Bonds have historically been a common source of income and a safe haven investment. However, in today’s low interest rate environment it is difficult to generate meaningful cash flow from bonds. Nevertheless, bonds should always be considered in an income investing plan.
The advantage of bonds is that you know what you will earn every year, and you know how much capital you will receive when the bond matures. Disadvantages include reinvestment risk: when a bond matures you may not be able to reinvest with the same yield. Bonds do offer liquidity, but values can fall between the date of purchase and the expiry date.
CDs, or certificates of deposit, are like a savings account, but have a fixed term. CDs are another of the more traditional types of traditional types of passive income investments. They pay a higher interest rate than most savings accounts, but in return you do lose some liquidity.
CDs are ideal for rising interest rate environments as the capital can be reinvested at a higher rate when each CD matures. They also provide certainty and are very low risk. In most countries, CDs up to a certain value are guaranteed by the government – so if the bank fails your money is protected. The downside of CDs as that capital is tied up for the period of the contract and returns are lower than it is from most other passive income sources.
Investing in dividend paying stocks is possibly the most popular way of creating passive income streams. This is particularly true in today’s low interest environment. If the value of a stock increases over time, even fairly low dividend yields can eventually generate a very high annual return on the initial investment. Imagine you buy a share for $100 that pays a $2.50 dividend. If the dividend increases by 20% every year, by year 10 you will be receiving nearly $13 every year, or 13% of your initial investment. By that time, the share will probably be trading higher too.
The secret to dividend investing is good stock picking. If you can find a company that is able to grow its revenue, and generate sustainable cash flow, the dividend yield and the share price will grow each year. The Dividend Aristocrats is a list of S&P 500 companies that have increased their dividends for the last 25 consecutive years.
One of the mistakes investors often make is chasing yield and buying the stocks with the highest dividend yield. While you should be trying to maximise your portfolio income, you also need to be sure a company is able to continue paying such a high dividend. Investors usually buy dividend stocks to generate an income stream.
However, reinvesting dividends can generate substantial capital gains too. This works just like capital gains in a bank account where compound interest leads to exponential growth over time. By reinvesting dividends, the overall yield and the capital value will increase faster. If your objective is to eventually create an income, but you don’t need the income right now, this is a good strategy. The downside to income investing with dividend stocks is that market volatility will affect the capital value of your portfolio.
Index funds, whether exchange traded funds (ETFs) or mutual funds, are designed to track a wide range of indexes. These include indices biased toward income generating stocks and other assets. If you are using index funds to build wealth or an income stream, it makes sense to use ETFs which charge lower fees.
There are two approaches to take if you are going to use ETFs to eventually generate income. The first approach would be to select ETFs targeting income. There are a wide range of funds to choose from, some with lower risk and lower yields, other with higher yields, put proportionally higher risk too. The downside to this approach is that index funds are unlikely to produce very high yields relative to the risk being taken. If you choose this route, you will need to be realistic about the yield you will earn. Ultimately, you will need a significant amount of capital to generate enough income to live on.
The second approach addresses the amount of capital you will ultimately need. If you will not need the income in the medium term, you can invest in ETFs that target capital growth first. You can start out investing in riskier ETFs targeting growth stocks. Over time you can move to more conservative ETFs, and finally to income generating funds. Either way, ETF investing can be used to generate a steady income stream or capital growth. However, investors must be realistic about the yield they will generate.
A robo advisor is a platform designed to create a savings plan and construct a portfolio around specific goals. Typically, the goal would be saving for retirement, or for a major life event. These platforms can be used to create a portfolio with the specific objective of generating passive income.
These platforms construct portfolios using ETFs and are very cost efficient. This includes ETFs that invest in equities, bonds, and money markets. For investors with limited knowledge or time, they are probably the best way to construct a portfolio of passive income investments using ETFs. The drawbacks are much the same as for ETFs themselves. Robo advisors are a good way to plan and save, but returns will be limited compared to direct investments.
REITs, or real estate investment trusts, are listed companies that invest in property. Investing strategies using REITs are another great way to build an income stream that increases over time. The return will depend on interest rates, property values and demand for rental properties. If property values increase, the value of a REIT share and its yield will improve with time.
Properties are categorised as either residential, retail, or commercial. Each segment has its own dynamics which affect the yield and capital value. REITs have a mandate that specifies the type of property and geographic area they can invest in. Because REITs are traded like shares, they offer an easy way of creating passive income streams. They also offer liquidity, unlike direct property investments.
In addition, it is easier to diversify a small portfolio using REITs. The biggest drawback of REITs is that they are sensitive to market volatility, interest rates, economic cycles, and property prices. Any investor wanting to generate cash flow from passive income investments should consider REITs. However, due to the risks, diversifying into other assets is advised.
Direct Real Estate
Investing in properties that can be rented out can be one of the most lucrative passive income strategies. People have amassed large fortunes by buying or developing rental property as accommodation, retail, and commercial space. There is however a trade-off. This is the most time-consuming approach to income investing. It can also be very risky and its difficult to diversify when investing in real estate. Real estate is also the least liquid asset class.
There are syndicates that invest in real estate and create passive income opportunities. This approach can reduce many of the drawbacks and risks listed above. However, these syndicates are typically only open to accredited investors and require a certain amount of capital. Either way, it’s important to do a lot of research before considering passive income investments in real estate.
Annuities are a type of policy issued by an insurance company. Annuities pay out regular amounts, which make them ideal for retirement planning. In the case of an immediate annuity, you will make a lump sum payment upfront, in return for regular cash flow in the future. In the case of a deferred annuity, you will make contributions over time, and then receive cash flows at some point in the future.
As with any passive income investments, annuities are a trade-off. In this case you will probably be giving away some upside, but in return you will receive regular cash flows. They also offer little liquidity. Once you enter into a contract, you cannot get your cash back without paying a large penalty. Nothing in life is absolutely certain, but the legal structure of annuities makes them amongst the safest investments there are.
There are lots of different types of annuities. Some will make payments as long as you live, while others pay out as long as you or your spouse are alive. In many cases an annuity can be structured around your specific needs. Annuities are ideal if you are happy to give away some upside and liquidity but want certainty over your income.
One of the latest passive income ideas to emerge is peer to peer lending. Platforms like Prosper, Upstart, Mintos or Bondora allow individuals to lend directly to borrowers. Usually banks act as a middleman between borrowers and lenders, and charge both parties. P2P lending platforms allow borrowers to pay lower rates and lenders to receive higher rates than banks would allow. Loans can be spread across numerous buyers to reduce risk.
From a lenders point of view, loans are structured like CDs, with a fixed term and interest rate. This does mean cash is tied up for the term of the loan. Lenders choose the credit rating they require, and rates are set accordingly. Though one would assume default rates may be quite high, evidence suggests this isn’t the case.
It’s worth noting that most P2P platforms have not been tested by a severe recession or rapidly rising rates. It’s possible that there may be more defaults under different conditions. As far as money making ideas go, P2P lending is something to consider, but should be treated with caution. P2P loans should be placed at the riskier end of the income investing spectrum.
Using the four percent rule to generate income
There is another approach to generating income, with a more balanced investment fund. The four percent rule is a rule of thumb used within the investment industry. Historical returns suggest that with a diversified portfolio invested in developed markets, you can withdraw four percent of the portfolio every year, and never run out of capital.
This means you do not actually need to invest in cash generating assets to produce regular cash flow. In this way you can turn growth or value funds into passive income investments. This approach is a good way to turn the wealth generating capacity of growth stocks into income.
Protecting your capital
No personal finance plan is complete without some consideration for risk. Passive income investments are susceptible to various risks, as are all investments. As with any portfolio, diversification can reduce the portfolio risk associated with individual investments. Your portfolio will also be exposed to market risks. If your income portfolio is part of a broader portfolio, effective asset allocation will reduce the effects of market corrections.
If you have all of your savings in income producing assets, you will need to pay more attention to potential impact of market volatility. Income producing securities like stocks, bonds and REITs are all sensitive to interest rates. This means, a spike in interest rates will probably lead to the market value of those assets falling. This will usually be temporary but can occasionally persist. You can however hedge this risk in several ways.
Hedge funds can protect your portfolio against short term volatility in the equity market. They can also protect your funds from black swan events like a stock market crash that can severely impair any portfolio. Catana Capital’s Data Intelligence Fund is an example of a hedge fund that can generate returns under any market conditions. Investments with guaranteed returns, like CDs and annuities can provide more certainty. Shorter dated bonds are a good hedge against rising rates as cash can be reinvested at higher rates upon maturity.
Finally, allocating part of a portfolio to precious metals or commodities will provide an inflation hedge. This does involve a trade-off as these assets don’t provide income. The compromise asset is real estate which is both a real asset and generates income.
Conclusion: Passive income investments as path to financial independence
A cleverly constructed income investing portfolio is one of the surest ways to achieve financial independence. As you can see there are a lot of different types of passive income investments to choose from. You definitely don’t need to invest in all of them, but you should diversify into at least three different vehicles. This will allow you to improve the yield, while reducing risk and providing some liquidity.