I tend to read a lot of MarketWatch when I’m bored, and the other night I came across this article about passive income. It triggered some ideas I’ve been turning over in my mind for some time, namely that so-called passive income is rarely ever passive, and that dividends can be somewhat misunderstood and therefore valued incorrectly due to a phenomenon known as the dividend fallacy and for a couple other reasons we’ll discuss.
I’ve pasted the MarketWatch article in snippets below to provide context for my comments. And, just to be clear, overall I think this is a great, thought-provoking article that was well-executed by the author.
The article has a good title, which definitely got my attention because who doesn’t love passive income and want more of it? The caption “it feels like free money” is interesting, because I think that for most people who have created passive income streams, it doesn’t really feel like free money at all, at least not while you’re figuring out how to get it going. Creating a passive income stream takes a lot of work on the front-end, and often takes plenty of maintenance work after the passive income has been set up.
A trust fund beneficiary who’s born into that position (lucky soul!) may have the most passive of incomes if he’s receiving regular distributions from the trust. Although he may feel that this income is truly passive, it wasn’t passive for those who built up the assets that were put in the trust. There’s going to be work involved, and probably a lot, at some point in the passive income creation and maintenance process.
Cutting Spending vs. Increasing Income
I like the point the author makes about increasing income. There’s an almost unlimited amount of room to increase your income, while expenses can only be cut so much. We all have to pay for housing, food, fuel, and other essentials, and there’s a limit to how far you can go without affecting your desired quality of life. Both saving and expanding your income are viable and useful strategies, but I believe that once you’ve dialed in your expenses (you’re utilizing wise saving tactics and you’re not trying to keep up with the Joneses), the wealth-building tactic to focus on the most is growing your income.
The article mentions getting a raise or side gig. Asking for a raise from your current employer might be one of the lowest effort ways to increase your income, assuming you are already providing value to your company and it can find room in its budget to give you an increase.
You will have to overcome the stress involved with having a compensation discussion, and you will have to continue working at the job, but I would agree that the act of securing the raise is low effort if you don’t count the work put in prior to and after the raise.
The first example of success excerpted below is a dividend strategy.
In brief, dividends are cash distributions paid by companies to their stockholders. These distributions are usually made quarterly, biannually, or once a year. The distinct advantage of dividends is that you have cash coming in and you don’t need to sell any of your stocks to get at the cash. The company basically makes that decision and does it for you.
The article does explain that there is upfront research involved in picking companies and that the dividend strategy investor doesn’t mind because he likes to immerse himself in that research. That’s fine and it’s great if you enjoy spending your time researching stocks but the work doesn’t end after you buy the stocks.
Companies that pay dividends may at any time suffer losses and encounter various economic difficulties that will force them to cut or eliminate the dividend. My point is you need to continue to be vigilant with these investments and monitor them on a regular basis. It is not a set-it-and-forget-it strategy.
Another point I want to make about dividends is one that isn’t talked about much because people do like their dividends, and I have to admit I have some bond fund holdings and I enjoy the regular distributions. So I get it.
However, dividends are often overvalued by investors due to a phenomenon known as dividend fallacy or bird-in-hand fallacy. Investors tend to attribute more value to cash distributions than to retained earnings, although the two are equivalent, setting aside transaction costs.
In fact, a company that is paying dividends is likely to experience less growth because it is not reinvesting in its own business but is instead paying out cash to its investors. (Remember that if your stock is trading at $20 and there is a $1 dividend payment, then following that payment the stock is worth $19.)
I would argue that it isn’t worth the savings in transaction costs to have a company that pays out its cash instead of reinvesting that cash for greater growth.
Another important consideration is the taxation of this dividend income. Unless the dividends you are receiving are qualified, then the ordinary dividends you receive will be taxed as ordinary income unless you are receiving distributions from a tax-exempt or tax-benefited bond product. This leaves you at a disadvantage relative to holding a stock which would reinvest the cash into its business rather than paying it out. By retaining the cash, the company would be choosing to grow its stock value over time.
If the company in which you own stock is reinvesting its cash rather than paying a dividend, you can choose to sell your stock position after a year or longer in order for your gains to be taxed at the lower long-term capital gains rate. In that case the same cash that would have been paid to you as dividends would be used to grow the company’s business and you would realize the benefit of that cash with a lower tax liability when you sold the stock after one year or longer.
Yet another very important consideration with dividends is what will happen to the principal you invest. A 10% yield may look great but you’re not winning anything if the principal you invested loses approximately 10% per year.
And actually the stock or bond vehicle would have to lose less than the initial yield for you to lose all of the expected benefits because of the additional tax hit you’ll be taking on the dividends. So you need to understand the strength of the company you’re investing in and realize that companies that offer high dividend yields are usually the riskiest.
I’ve done my share of investing in bond funds and high yield stocks and I can tell you that there most certainly is no free lunch to be had. These investments come with plenty of risk, so the valuation at which you buy is paramount.
One way to get in trouble very quickly is to focus on only the yield or dividend payment being offered and invest based on that. I have had plenty of experience where I take a position expecting 5-10% a year of distributions and within a few months of my investment the dividend is cut by 10-25% or more and the stock or bond vehicle takes a sizable hit as well.
Investing in stocks and bonds, and using dividends for income is a great strategy, but there is risk, and there is upfront and maintenance work involved. It’s worth learning about before taking the plunge, that’s for sure. I wish I’d delayed my investing by a year and spent that year learning and researching instead.
The investor mentioned in the article is taking a wiser approach than I took initially. It seems he is aware of the risks of over-concentrating in dividend stocks and he is diversifying accordingly.
I think that with the right research and approach, stocks and bonds are the freest of the lunches to be had here. Of course there is also a subjective component. If you find writing books or creating art to be easy or enjoyable, then the work that you put into creating intellectual property may not seem like work to you at all. And with that, let’s move on to IP.
Intellectual Property and Services
In this next passive income success story, Cat developed intellectual property, and is now selling licenses for it, as well as providing professional services. I really like this one.
Of course this strategy requires special expertise and the ability to successfully create intellectual property that others want to use. If you can do this, that’s awesome, and I’m jealous.
For all you artists and inventors out there, this is a great path to income. After the upfront study and skill development is complete, and also after product development are complete, the income becomes increasingly passive.
You could negotiate your license agreement and then do nothing if you so chose, provided the income was adequate to pay your bills. Then you wouldn’t need to do anything until the license agreement needed to be extended. But I bet if you’re a person whose ideas and creative works are licensed, you’re not going to be sitting still much. Creating is what you do.
I’m no good at the artistic side of things but I was recently helping a friend with a patent opportunity, which was a very interesting experience. Unfortunately, our preliminary research revealed that the product had already been patented and was on the market. It is also fortunate that this happened because it seems there is not nearly as much demand for the item as we thought there would be, so it saved us a lot of time and effort. I’m sure we will do more brainstorming in the future, because it was fun for us to attempt to think outside of our respective boxes.
The next two examples are of rental income from rental properties.
Rentals can be a good income source but they do come with their fair share of work on the front-end and on the management side. Once you’ve accumulated the savings needed to buy the rental properties, you will still need to manage or hire someone to manage the properties and deal with the tenants.
I’ve been wanting to pick up some rental property but I’m not seeing any good deals right now and the more I look at it the more I realize I want to increase my real estate assets because I like the fact that they are real, even though this is only vaguely rational. I know that the return on paper assets is generally much greater, even without the leverage that is available for real estate investing, and yet I still have this lingering feeling of wanting real estate.
How much additional security do real assets actually provide if they’re in the same country whose laws govern your paper assets? If something awful happens to our financial institutions such that we can no longer access the value in our accounts, it’s unreasonable to assume that real property ownership won’t be affected as well. Your physical gold overseas, or your land in other countries, may be a more effective diversification tool in that unfortunate case. Tangent over.
Back to real estate. Maybe when the market dumps, if that ever happens (the business cycle will kick in again, I’m sure of it…), I’ll think about putting some cash to work in real property, and/or perhaps a paper asset version of it such as VNQ, which is Vanguard’s REIT ETF. I’ve had my eye on that one for a while, but it’s currently too expensive for my taste.
Passive income is great if you can get it and if you can find ways to enjoy the journey to it. I think that’s the trick of it. Find the passive income strategy for which you don’t mind putting in the work, and the returns will seem passive even if you are putting in effort.