Passive Income — for real

I see a lot of posts on Medium and elsewhere on the web claiming to have secrets to passive income. Most of them are really gimmicks to sell some kind of “information” about how you can make money as a side hustle, writing, selling online, or fooling other people into buying your own information product about making money. This isn’t one of those. I would just like to share a real and practical path to generating passive income that is available to everyone.

Here’s the deal. You can make money in only a few ways; getting paid for your work, getting paid for what you own, or inheriting. Everything else falls into one of those categories.

When people talk about making passive income what they mean is that they are going to continue to get paid without having to continue working. It’s passive because it doesn’t require more effort.

Nothing is perfectly passive. Income sources are on a sliding scale from labor-intensive to passive.

It’s usually at this point that a writer will start telling you about different methods that are “so easy” and “foolproof” with “just a little effort”… So, technically if you were to write a blog about rakes, and then place affiliate links on your blog to sites that sell rakes, you could make passive income from those ads. But practically that’s not true. You will need to refresh the content, advertise to get people to come to your site, keep writing new reviews, and engage on social media to bring attention to your blog. That’s fine and doable, but it is not passive.

You could invent something, patent it, license it, and then just collect the royalties. Yep, and you could learn an instrument, form a band, write great songs, sell out to huge stadium audiences (well, maybe after 2020), get a record deal, and just start collecting royalties. “That ain’t working, that’s the way you do it…” Alternatively, you could just be amazing looking, get discovered as a model, turn that into an acting career, and after working for years at the top of your field just live off those sweet, sweet Netflix royalties. I think the odds of this are similar to me playing in the NBA.

Those ideas are kind of bullshit. If you want passive income the reality is simple:

Own things that entitle you to payments and then collect the money. If the things you own don’t require you to take care of them, maintain them, sell them, etc. then that’s passive income.

Are rental properties passive income? Well, sort of. If income is on a scale from labor-intensive to labor free, owning rental properties is definitely more on the labor free end of the scale, the passive end of the scale. But is it actually passive income? Well, are you managing the property? Collecting the rents? Advertising for and screening new tenants? Going to court to evict someone? Cutting the grass, painting, replacing appliances? If you are managing the property, you are putting in “sweat equity” and to whatever degree you are doing that, it is not passive income. It’s income and can make you a lot of money, but it is not passive.

Okay. So, are there things you can own that will entitle you to payments and not require additional work from you? Yes. I am going to ignore the possibilities like us buying the Beatles catalog of songs and getting paid royalties on them. Or buying the patent on squeezable ketchup bottles and turning that red to liquid green. I don’t know anything about how to do that, and I suspect it takes more money than either of us can scrape together.

Realistically, in my opinion, the best things that you can buy to generate passive income are shares of companies that pay dividends.

What is a dividend? A dividend is a payment made by a company to its owners. It is usually a portion of the profits of the company to which an owner is entitled. You own a piece of a business, it earned income and after paying expenses had money left over. That’s profit. That’s the owners’ profit. Companies either reinvest that back into growing the business, save it for a rainy day, or send it to the owners as a dividend.

Some companies have long track records of paying dividends every three months (each quarter of the year). For example, I own shares of Exxon Mobil. Exxon is an energy company. They pay me a dividend every three months. Why? Because I am a partial owner. What’s a share? A share is a piece of ownership of a company. Exxon is a huge company. Lots of people own pieces of it. Exxon’s ownership is actually split up into tiny pieces, 4.2 billion of them. Each piece is one share. I own about 250 shares. Not even a drop in the bucket. But every quarter I get my little payment, about 87 cents per share. So, about $200 four times a year.

Why am I using Exxon as an example? Well, it was a bad year for Exxon. They got kicked out of the Dow Jones Industrial Average; Covid and the lockdowns killed energy consumption, and they aren’t very green in a world looking for renewable energy. But, even with all of that bad news, I still got my quarterly dividends. I am a part-owner of Exxon and they pay their owners well.

If I want to sell my shares to someone else, they currently go for about $41 per share. I don’t want to sell. Actually, I want to own more. Like a kid playing monopoly I just want to buy properties and get paid, I never want to sell. In the very long run I, or my heirs, probably will sell these shares, but by then I will own many many more. How? Dividend reinvestment.

You see, while I really want a passive income, right now I don’t need it. I can live off of what I earn from work. What I want to do now is build a passive income. And in my opinion, for most people, the two best ways to do that are; 1. Regularly buy shares of dividend-paying companies, 2. Reinvest the dividends to buy more shares.

Will I get rich quickly? No. Will my shares go up and down in price over time? Yes. Does that worry me? No. Why not? Because I diversify and plan to hold my shares for a long time. In the long run, most of them will go up in value. In the meantime, I will get payments for holding them.

So, to sum up, you get passive income by owning something that entitles you to payments just for owning it. I think the best thing for most people to own that entitles them to payments are the shares of well-established, dividend-paying companies.

Do you need to learn a lot about stocks to do this? Not anymore, and not for a couple of decades now. It used to be that in order to own shares of companies you would need to place an order with a broker to buy shares for you of a company that you wanted to own. But for a while now there have been other ways to buy stock (shares of companies). My favorite is a mutual fund or an ETF (exchange-traded fund). I am going to keep this really simple. Imagine 100 of us got together and pooled our money; you put in a couple of thousand dollars and so did everyone else. Then we hired a manager to buy shares from lots of companies that paid dividends and each month calculate our share of the profits based on our proportional ownership of that “mutual fund”. People who invest in mutual funds don’t need to pick stocks, the fund manager does that for them. They just own shares, and if there is a dividend from any of the companies they get their payments. ETF’s are very similar, they are mutual funds whose shares get bought and sold on an exchange just like other public companies. This way you don’t need to know the manager or have any connections, you can just buy shares of funds that you think are well-managed and have a good strategy.

Here’s my suggestion, pick a low cost ETF that invests in dividend-paying companies. My personal choice is Vanguard’s ETF called VHYAX — Vanguard High Dividend Yield Index Fund. It focuses on large US companies that pay above-average dividends. I am fine missing out on the next TESLA or Amazon. I am looking for capital preservation (not losing my money) and high yield (getting paid dividends). I am trading away possible big winners for less risk.

Is this a pitch for Vanguard? Nope. I like Vanguard, but you go with whoever works for you. Vanguard is a not-for-profit company that runs funds for the benefit of its customers. They have low fees and decent options. Their website is reliable but neither pretty nor particularly intuitive. I take that to mean they don’t care much about user experience. They focus on investment returns and on keeping costs low. That’s fine with me.

Over the last couple of decades, I’ve owned shares in lots of individual companies. I still own some, like Exxon as described above. But, I rarely buy individual stocks anymore. Why not? Because picking stocks is a full-time job and I’ve already got a different one. In my personal experience, I’ve picked some real winners and some losers. So, I don’t try to beat the market anymore, I just buy a big spread of it with the ETF.

Summary — Rules to a real passive income

1. Earn money
2. Save some of it
3. Invest automatically every month in dividend-paying stocks*
4. A dividend-paying ETF is better than individual stocks
5. Collect dividends
6. Automatically re-invest until you want/need the money

How

Open an account with an online brokerage, like Vanguard or Fidelity. Connect your bank account to your brokerage account and set up an automatic withdraw from your bank account into your brokerage account scheduled for once a month. How much? However much you feel comfortable investing each month without a decision. I am not linking to those sites here on purpose. I don’t want to make this seem like a sales job for something. I am not getting money for this article. If it helps you, great.

If you do the above method, reinvesting the dividends as you go, in 15 years you will be earning about as much in dividends every month as you are putting away in new savings. In 20 years it will be twice as much, meaning if you invest $500 per month every month for 20 years and keep re-investing the dividends, then after 20 years, you will be getting about $1,000 a month in dividends. If you do it for 30 years, your dividend income will be over $2,500 a month. You’ll also have a ton of wealth.

It really adds up.

$500 a month for 20 years, at a 3.5% dividend yield, and an average of 6% growth rate (conservative historical average), will leave you with about $330,000 dollars invested and an income of about $1,000 per month. If you keep going until 30 years, you’ll have about $1,000,000 and more than $2,500 a month in income. That’s like having a $40K a year job, but you’re not working for it.

I am keeping these numbers simple, but they are pretty good approximations. If you double your monthly contribution you will double your results. $1,000 a month for 20 years, will result in about $660,000 in wealth and an income of $2,000 per month. If you keep going until 30 years that will put you at about $2,000,000 and more than $5,500 in monthly income. That’s like you getting an $80K a year pension in retirement, plus having $2M in the bank.

$1,500 a month and you will have that $1M in 20 years and nearly $3M in 30 with a monthly income of more than $8K a month.

It’s boring. It’s dead simple. It’s as passive as you can get.

I would like to make this essay helpful and both as clear and pragmatic as possible. Comments, suggestions, and questions are all very welcome. My agenda is to help as many people as possible increase their financial security with a real and realistic passive income.

Thanks for reading and commenting,

Joe