One of the things I’ve always wondered is if there is such a thing as passive income? You know like the perpetual motion machine, set it and forget. The Wikipedia link I referenced gives some examples of passive income and how the IRS defines passive income. My argument, just like perpetual motion, is that true passive income does not exist and is lore of late night infomercials. No investment is set it and forget, so it can’t be passive. Ask the investors of Bernie Madoff how that worked out. I would argue there is residual income – income that continues for a period of time after the initial investment of time and/or money. Residual income will continue for awhile – it could be days, months or years, but eventually it will stop producing income unless you actively maintain it. No product or service has an unlimited life, and therefore eventually needs maintenance or updating.
In reality most investments require a decent amount of research, preparation, and work to get going. Even though the IRS defines it as such, investing in the stock market isn’t passive. How many hours of research was needed before you are invested in your first stock? How many books did you read? Who did you talk to about investing?
Then there is the monitoring and maintenance. Even when investing in stocks you need to keep informed with the company and read their financial statements. What once was a great business can go sour. A rental property eventually needs repair. As an entrepreneur your goal should be to minimize the effort needed and automate daily operations as much as possible. The best you can strive for is your business generates income while you sleep. That’s the best you can do. Meaning unlike a job or a consulting business when you get paid by the hour, you have a business that can generate income when you aren’t physically there. In the online world this means:
- Ad banner based web site (i.e. a blog)
- Selling a product or service online
I’ve seen people mention blogging as passive income and chuckle at the mention. If it’s so passive why does it require a decent amount of time to create articles, maintain the web site, and read/comment on other blogs? While it’s nice to think an article you write will reap riches forever, the reality is:
- Technology changes.
Using the reference of a blog, search engines change their algorithm. Back when I first started in the Internet industry the way to the top of a search engine was just repeat the keywords on your web page. Right now links and back links is what’s currently popular with the search engines. I suspect in the future social media will play a much bigger weighting in search engine results. This means your content and SEO strategy would have to change. What got you to the top of the search engine results won’t in the future.
- There are competing businesses
Your income generating scheme exists in a somewhat free market. You don’t live in a vacuum. If your product or service develops a decent amount of income, don’t you think others will figure this out and start competing? Competition reduces the profit margin of other businesses in that same industry, which reduces your residual income.
- You need others to produce
A business needs people to produce output. The work either needs to be done directly by you, or you pay someone else to do it. Since this investment was supposed to be “passive” you’ll hire others to do the work. This eats away at your net profit.
Unless you are a trust fund baby, you must initially produce earned income before you generate residual income. Any income producing business idea either needs money or effort and usually both. If it’s money you are investing, in some shape or form it was originally earned income. To take this discussion one step further – it can be argued a loan is just stealing from future earned or residual income and using it now. The trick is compounding your earned income multiple times. Let’s use an example: Your earned $100,000 after taxes from your job. You take that earned income, and invest in Lending Club notes. On average Lending Club users generate 9.67% APY, so that means you would earn approximately $9,670 annually. For the sake of simplicity let’s not discuss taxes or fees. You can either take the $9,670 and either reinvest it (into other Lending Club notes or say a new business) or consume it by buying a nice home theater system. If you reinvest it, you are compounding your initial earned income. In most cases if you consume it the asset isn’t generating any income.
Bottom line, every investment needs constant effort to monitor and maintain.
Readers: What is your opinion? Do you disagree?