The advantages and disadvantages of passive income
September 5, 2018
What is passive income?
Passive income is a periodic stream of income. An apple tree creates a stream of income every year by producing apples. Your first experience of passive income was probably the monopoly game. You bought hotels, and whenever someone landed on the hotel, he or she had to pay rent. The term passive is somewhat misleading – the few assets which are 100% passive are dividend income index funds. Most other assets require some percentage of your time.
Passive income vs capital gains?
There are three main ways to earn money.
- Capital gains: The underlying asset rises in value and is sold at a profit.
- Labour: Where time is exchanged for money.
- Passive income: Where an asset generates an income, but its base value is not changed each time this revenue is generated. Passive income is the difference between the income and the expenses incurred in managing the asset itself.
Advantages and Opportunities of passive income
- A Quarterly or monthly income is more in tune with the human cycle of expenses paid. This makes for more natural planning of one’s financial future
- Companies which distribute cash dividends are more solid than the ones who do not because it is tough to fake cash flow. However, beware this does not apply to many crypto projects.
- Millionaires have at least seven streams of income. Emulate them if you would like to become a millionaire!
- Cashflow gives you the ability to diversify without the pressure of selling assets.
- Passive income can be very interesting (and risky) and can also be more than just investing and can be a hobby. Those who would be more hands-on can find a lot of opportunities in Passive income investments such as stocks, crypto (example: Passive income from crypto exchanges) and even agricultural projects.
- A passive income portfolio which can supplement your lifestyle will allow you to retire earlier knowing that the withdrawal rate is not an issue. When a portfolio has only capital appreciation investments the best withdrawal rate is only a guess, no one knows when they will die.
- Less likely to sell in a panic because it is more difficult to liquidate, especially real estate
- More likely to diversify and to do so on a dollar cost averaging basis. Since passive income usually comes monthly or quarterly. This provides the opportunity for the investor to reinvest periodically and in different assets.
- With a passive income stream, one can pursue personal interests rather than exchange time for money.
Disadvantages of passive income
- 100% passive investments do not exist. There is a spectrum of activity in passive income. The most passive being income index funds.
- The compound interest in capital based investments happens automatically. A company that does not issue dividends reinvests the profits into the business.
- Taxes are paid on income every year; this is a disadvantage because that money could be compounded faster more if taxes were not deducted each time income is earned.
- Scams: Passive income scams and fraudsters abound both in the crypto and in alternative investments.
- Inheritance taxes are more difficult to manage in case of passive income assets because it is usually challenging to liquidate only part of an asset. When the title of an asset such a real estate is moved from those who passed away to those inheriting the property, usually there is a tax incurred. In case of assets such as stocks, part of the assets can be sold to pay for the taxes this is more difficult in case of property. Property is the most common form of passive income asset.
Some investors may sell their passive income on lifestyle inflation rather than reinvesting it.
There is no rule which states an investment portfolio should be strictly passive income or strictly focus on capital appreciation. One can have a mix of these types of assets. Passive income is excellent as it allows you to leave a lasting legacy with your personal touch.