Everyone wants to get some “passive income” but what most think of as passive income isn't usually very “passive”. Be prepared for some work and risk.
Today’s Classic is republished from The White Coat Investor. You can see the original here.
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Passive income is a big deal these days, just ask Passive Income MD. Everybody seems to want to get them “some of that passive income stuff.” Well, the truth of the matter is that income is a spectrum. It ranges from getting paid on an hourly basis to dig ditches on the 100% earned side and all the way through a whole bunch of stuff like rental properties, books, websites, and various types of investments until you get to the other side. But the truth of the matter is that most income has at least some sort of earned income component.
Think about a rental property. Sure, every month you get this sweet rental check in the mail. But you had to search for the property, buy the property, fix up the property, find the tenant, screen the tenant, and take care of any issues that came up. There are definitely some elements there that sound a lot more like “job” than “passive income.” You can hire lots of that out, of course, and the more you hire out the more passive the investment becomes and the lower the return you get from it because a significant chunk of your return is really a payment for your work.
What about something like a book or a course? I feel like I can speak about this, having published both a successful book and a successful course. Both represented a big chunk of several months of my life. Hardly passive. In this sort of income strategy, you put plenty of work in, you just do it upfront and often without any certainty of a payout.
Perfectly Passive Income
So if digging ditches is at one end of the spectrum, what’s at the other end? What is the most passive of income that you can find? This would be something that takes only seconds to set up, that sends you “mailbox money” regularly, and that requires no ongoing work. That’s a mutual fund. Specifically, an index mutual fund and even better, a fund-of-funds that invests entirely in other index mutual funds.
Consider the Vanguard Target Retirement Income Fund. This mutual fund has an all-in price of 0.12%, practically free to all but the pickiest of Bogleheads. It invests in a conservative mix of most of the stocks and bonds in the world. Here is its asset allocation:
- Total Bond Market (US Nominal Bonds) 37.4%
- Total Stock Market (US Stocks) 17.9%
- Short-term Inflation-Protected Securities (TIPS) 16.8%
- Total International Bond Market (International Bonds) 15.9%
- Total International Stock Market (International Stocks) 12%
70% bonds and 30% stocks. Its yield is about 2%. So for every $100K you invest in it, you can expect about $167 of passive income per month, $500 per quarter, or $2,000 per year.
It requires no research to buy and no managers to check out. Anybody can buy it in seconds with as little as $1,000 and there is no ongoing maintenance. Passive income in a package. The ultimate passive income.
In addition to the passive income it kicks out, the fund will likely continue to increase in value so that yield is calculated on a higher and higher amount of principal each year. Its total return has been 6% over the last 5-10 years. It rarely drops in value, the last time was in 2008 when it lost just 11% of its value in the Global Financial Crisis.
But 2% Sucks!
So what’s the problem? Well if you ask anyone with an interest in passive income they’ll quickly list off the issues with this fund as a source of passive income:
- Requires money
- Only has a 2% yield [Update 9/2020- the yield is now down to 1.76%]
- Only has a 4-7% expected return
They would argue that the perfect passive income requires neither large quantities of money nor significant amounts of work and has a double-digit return, most of which is yield. Guess what? It doesn’t exist. The reason this mutual fund has such low returns is it requires you to take very little risk and do pretty much no work at all. Most of those big checks you get from more traditional sources of passive income come as a result of taking risk and/or doing work. I’m sorry, that’s just the way it is.
Take syndicated real estate for instance. You’re taking on manager risk, single property risk, and interest rate risk. You’ve got to be accredited (which means you lose a lot of the protections provided by government regulatory entities) and you’ve got to fill out dozens (and read hundreds) of pages of paperwork just to invest. And every bit of work you want to avoid is going to cost you something. Nobody works for free, and those in the investment industry have a nasty habit of wanting to get paid more than anyone else. And you’ve at least got to do some due diligence work upfront.
Well, what about your own business? You could start a blog. They’re passive income, right? Consider that I wrote over 500 blog posts before ever making $20K with no guarantee I’d ever make any more than that. Does that sound passive to you? Everyone wants to “build an audience” with a blog, podcast, videocast, or Facebook Group. Guess what? It’s not that easy to build an audience large enough to be worth your time generating income from it. How much income do you think you can generate from an audience of 100?
What about a book? You could write a book. You’re a smart person. Guess what? The average book published through a traditional publisher pays you a buck or two per copy sold and the average book sells 3,000 copies. Do the math. We’re talking $5K of income. Divide that by the number of hours you spent writing the book to get your hourly rate. But you could self-publish, some of those folks are killing it! Instead of only getting a dollar per book, perhaps you get $10 per book. Unfortunately, the odds are even worse for self-publishing. The average title sells 250 copies. No, I didn’t forget a zero. Do the math — $10 x 250 copies = $2500. But now you have to include not only the time you spent writing but the time you spent marketing it to calculate your hourly rate of pay.
You can charge a lot more for an online course, but guess what? They’re MUCH harder to sell in any significant number. I know people who do these FULL-TIME who are thrilled to sell a handful a month. And I assure you they must be sold.
How about a franchise? You could get a Chick-Fil-A or a Baskin-Robbins. The truth is that most of those folks bought a job, not a source of passive income. Even if you hire managers, you’ve got to manage the managers. Now I’m a big fan of entrepreneurship, but I don’t know any successful ones who consider their income to be mostly passive, much less completely passive.
Time to Get Real
No. If you want truly passive income, you’re stuck with traditional investments. Treasury bonds, CDs, mutual funds, REITs and similar. So quit looking for something truly passive and realize that what you are looking for is mostly passive or even just partially passive income. And be prepared to both work and take some risk.
What do you think? Have you spent any time trying to find some passive income in your life? What has worked for you and what hasn’t? Comment below!