Does Passive Income Really Exist?

by Mr. Cheap

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I love the idea of passive income.  Some magic is performed, and a steady stream of money comes into your life every month.  A Google search on this site with the term “passive income” turns up 55 hits, so its definitely a popular topic.  As much as I think passive investing in index funds is pretty tough to beat, real estate and dividend paying blue chip stocks that offer regular cash payments are pretty enticing.

Mike has made the point that there isn’t a big difference between being sent some money every month or redeeming a small portion of a stock portfolio as needed.

People will sometimes suggest things like writing a book or writing a song as a way to generate royalties which becomes a “passive” income stream.  While collecting the royalty checks is passive and easy, writing a book sure wouldn’t be (especially if it was any good).  Taking a risk that the public will like your work, investing all the labour upfront, then getting paid out over time seems like reasonable trade-offs for the income stream.  Why is this better than working hard at a 9-5 job and collecting a check for your efforts?  Both seem like reasonable compensation for the amount of work, risk and delay of payment involved.

Often passive income streams are proposed that aren’t very passive, such as real estate or starting a business.  I don’t buy the suggestion that a property management company or hiring employees will make these totally passive.  I’d say with either of these options you’re sacrificing income to DECREASE the amount of labour you need to invest (which is ok, but its just a trade off like any other, nothing magical).  If you turn over the company ENTIRELY to other people to run, I think you’re sending your risk into low Earth orbit.

Paul Graham proposes the idea that startup companies condense a lifetime worth of labour into a couple of years (and pay accordingly). While this isn’t a passive investment (usually founders sell their company and walk away with a big check rather than getting monthly payments for life), it does seem like a reasonable way to spend a couple of years if you have a good idea and are confident in your ability to build a company that could be sold.  It would be possible to live off the the proceeds of the sale for the rest of your life.  Similarly someone could sell the rights to a book or song, and then live off that money.  How is this getting paid upfront worse than an income stream?

GICs (or CDs for our American readers) pay money over time, but these are rarely recommended as a passive investment.  The higher returns from what is usually considered passive income seem to me to mostly be a risk premium.

Choosing the right combination of length and amount of investment, amount of risk tolerated and labour invested seems to me to be considerations all investors make, from Donald Trump to whether you want to work at the McDonald’s or at your friends new car detailing business.

Is there an important aspect of passive investing or income streams that I’m missing?

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{ 6 comments… read them below or add one }

1 Nurseb911

For me individually it’s all about the “tax efficiency” of the income stream.

I know that I’ll pay taxes on my dividends until retirement, but that will be well under what capital gains taxes will be. At retirement my hope is that the effect of the dividend tax credit (for CDN residents) is still a 7-8% rebate on that income stream. If I can pay no tax or receive a refund for my dividend income stream than that’s a much bigger advantage to me than paying CG’s if I need to start redeeming shares in order to secure income in retirement.

2 Mr. Cheap

Brad: Yes, the taxation of Canadian dividends is pretty sweet (I just wish I had a higher income so I could benefit from it more ;-).

3 Dividend Growth Investor

I think that most people confuse the terms passive and alternative income. It’s all about having a diversified income stream so that when one dries up you don’t end up eating cat food in your fancy box house on the street.

Anyways I like the idea of purchasing dividends stock in many companies and holding on to them for several decades.. watching the dividend payments rise over time is definitely a great exercise in passive income..

I think that with dividend stocks you only spend a little bit of time now and then you have a lifetime of income potential…

As for passive income, I think that Forbes Dead Celebrity earners list is definitely a true list of passive income ventures..

http://blogs.forbes.com/digitaldownload/2008/10/dead-celebritie.html

4 Mr. Cheap

DGI: I’d definitely agree with that: that its good to have money coming in from multiple sources…

5 Gates VP

I don’t really think there’s really a “passive income”, just the usual gradients of labour intensity vs. returns.

I guess we all draw an imaginary line on the returns / labour ($ / hour) curve and say that anything above some really high $/hour is indeed passive. But we all have different spots at which we draw that line.

I don’t know of any investment that can made ad infinitum with zero additional time/resources required for maintenance. But some things (like managing a good dividend portfolio) are definitely high enough to count as “reasonably” passive.

6 Nurseb911

When I was in nursing school I was making just under $35k per year from a part-time job & consulting. Dividends at that time would have yielded a tax rebate of ~$0.07 for every $1.00 in dividends I receive. That has now flipped to about 7% tax on dividends but as a student you should be benefiting from it more than someone in a higher tax bracket Cheap :)

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