You may have seen articles or postings on social media about how to generate “passive income,” suggesting you could “Make Big Money Without Doing Anything!” In this article, we debunk the myths about passive income, discuss when it could be a realistic complement to your main source of income, and explain why we firmly believe the best way to achieve your financial goals does not involve attempts to get rich with no effort (because there is no such thing).
We first frame the discussion on active versus passive income, but we rename them to better communicate what they really mean. Then, we introduce the concept of Portfolio (or “Investment”) Income and address how this all fits into achieving your financial goals.
Active Income
We rename “Active Income” as “Primary Money-maker." This is income earned as a result of being actively engaged in some type of work. That might be in the form of a paycheck you receive from doing a job at a company, your share of the profits generated from a private practice, or what you pay yourself from the income generated by running your own business. This income comes from the fruits of your labor, and thus, it reflects the return on the investment you have made in yourself that has allowed you to develop some type of expertise that generates payment.
We call this your Primary Money-maker because it is the source of the income you need to cover today’s expenses, and it is the source of your savings that, when invested over the long term, will become wealth that generates income for the rest of your life. Looking at it this way, you can see why we believe that until you retire, you should focus the vast majority of your income-generating efforts on this category because it offers you the highest rate of return on the effort you expend.
Passive Income
The IRS defines Passive Income as “trade or business activities in which you don't materially participate. You materially participate in an activity if you're involved in the operation of the activity on a regular, continuous, and substantial basis.”
We rename Passive Income as your Side Hustle. Passive income is typically defined as money earned from sources other than a traditional job that requires little time or effort. The idea of truly passive income is that you can just lie on your couch and watch the money come in. Most of the articles you see on generating passive income suggest things like publishing a book to earn royalties or posting videos on YouTube to earn ad revenue. Of course, that ignores the fact that you have to write the book or create and promote the videos. That’s hardly passive—it’s a lot of work! The “return on effort” you earn from producing such things is almost always very low (often zero), unless you are deeply motivated and truly talented.
Pursuing these passive income ideas takes time and energy away from your Primary Money-maker, your main source of income and wealth, so it’s important to consider the opportunity cost involved. If you stay up late creating videos that generate a few dollars in ad revenue, you are probably not getting the sleep you need to be at your best when doing your Primary Money-maker job. If you want to write a novel in your spare time because you enjoy doing so, that’s great – but think of it as a hobby, not a source of passive income.
Some side hustles can leverage the expertise you have developed doing your Primary Money-maker work. This might be teaching a class as an adjunct professor or doing expert witnessing (the latter can be fairly lucrative). But again, these activities are not passive! Designing and delivering lectures and grading exams for a college-level course, preparing to testify in a deposition, or being cross-examined in a courtroom takes a great deal of time and effort.
What about owning real estate?
The source of “passive income” most people think of is owning real estate and collecting rent. In fact, unless you are a real estate professional, the IRS specifically identifies rental real estate activities as passive activities, even if you materially participate.
Many buyers purchase property thinking they can just list the property on Airbnb or a rental site and watch the money roll in. However, unless you have a portfolio of real estate properties – enough to justify paying a property manager to handle the problems for you – be prepared to deal with the “3Ts” – tenants (who don’t pay on time), toilets (which will clog), and trash (that must be cleaned up after tenants leave or no one will rent from you and the value of the property will plummet). The three Ts are not fun to deal with, and they take a lot of time.
If you want to own real estate, we believe generating income should not be the primary reason. Perhaps you want a vacation home that you and your family can enjoy, but plan to rent it out from time to time to defray some of the cost of ownership. That can work (but remember, the plumbing will back up at some point). Remember the old adage: if you love doing something, start doing it for money and you’ll end up hating it.
The only exception: doctors or other professionals in a private practice who own the building where the practice is located. The value of the property should increase over the long term (we’re talking about 20+ years), and when it’s time to sell your practice and retire, selling the property often brings in more than selling the practice itself. Or, you might sell the practice and keep the building to generate ongoing income. Remember, either way, this is only a source of meaningful income because of the effort you put into your Primary Money-maker, so it’s not really passive.
Portfolio Income
Portfolio income, or “Investment income,” is the only true source of passive income. You invest in a diversified portfolio of assets whose value is expected to increase over time (note that we said “expected”, not guaranteed, but if the portfolio is diversified its value is almost certain to grow over time). The portfolio may generate income in the form of interest or dividends, and you can liquidate portfolio holdings to create income after you retire. That requires no effort on your part, other than to work with a qualified financial advisor to construct a portfolio that is right for your needs, a portfolio that passively generates income while you lie on the couch, go for a hike, take art classes, or whatever you want to do.
Let’s go back to real estate for a moment. Many people believe that real estate generates higher returns than a diversified portfolio of stocks and bonds. In reality, returns from real estate are usually no better than what you can earn from an investment portfolio that requires no effort on your part. If real estate generated such great returns, more people would jump in and buy property. That would push prices up, and you would have to charge higher rent to cover your costs, which may not be feasible. You would also be betting you could find someone willing to pay an even higher price when you want to sell. Even in a market where home prices seem to be rather bonkers, the returns are not great when you consider the work involved. If a home’s value doubles in six to seven years, that’s about a 15% annual return, before taxes.
People who are fearful of market volatility often think that owning real estate gives them more control, but let’s examine that assumption. The rent you can charge your tenants is not really in your control – it's determined by market forces (supply and demand). Who determines the value of the property when you want to sell it? The market. And, of course, real estate is highly illiquid – if you need income now but can’t sell a property at the price you think it’s worth, you have a problem. You can always sell a slice of your investment portfolio to raise cash immediately, but you can’t sell a few square feet of your property. Also, your portfolio can’t burn in a fire or suffer flood damage. In other words, the notion that investing in real estate gives you more control is an illusion. As noted above, it’s not passive – we assume you do not want to spend your leisure time dealing with the three Ts.
Following Good Advice Boosts Your Passive Income Potential
Unless you have inherited enough money to live on for the rest of your life, generating income requires effort, even collecting royalties, selling things on eBay, or renting out your spare room—our advice: put your effort into your Primary Money-maker activity. With guidance from a trusted financial advisor and discipline on your part, you can build an investment portfolio that generates truly passive income instead of worrying about the occupancy rate of an apartment complex you bought into in some part of the country you know nothing about.
At Gold Medal Waters, we truly believe that part of the value we provide is helping our clients evaluate enticing pitches about “can’t lose” real estate opportunities or “guaranteed double-digit returns” and so on. We can be objective about such things because we have no axe to grind, no agenda to push, and we don’t earn any commission for promoting any investment. Our focus is solely on helping you to reach your financial goals based on your life’s priorities – and that’s not a passive endeavor for us; it’s our purpose.
Disclosure: Advisory Services are offered through Gold Medal Waters, a Registered Investment Advisor. This post and material presented are for informational and illustrative purposes only, and do not constitute investment advice and is not intended as an endorsement of any specific investment. As such, this material is not client-specific, we make adjustments in individual portfolios based on each client's financial plan, income needs, risk tolerance and total asset allocation. Interactive checklists are made available to you as self-help tools for your independent use and are not intended to provide investment advice. While Gold Medal Waters believes information derived from third-party sources to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability in regard to your individual circumstances. Investors should carefully consider the investment objectives, risks, charges, and expenses associated with any investment. The information discussed is not intended to render tax or legal advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Investing involves risk including the potential loss of principal, and unless otherwise stated, are not guaranteed. Past performance does not guarantee future results. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Consult your financial professional before making any investment decision.
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