Building a passive income is the best way to become financially free.
If that sounds like a bold statement to you, I\’d ask you to look at a list of the world\’s wealthiest individuals and see what they do for a living. Entrepreneurs and investors are those individuals who have realised that working for someone else isn\’t the best way to earn an income, but rather seek to own cash generating assets to reduce their reliance upon a single source of income (for example, your university degree). Now, don\’t get me wrong; I believe education is one of the most valuable assets available to any of us. The ability to understand, engage and explore the world around us is crucial to our happiness and well-being, as well as being critical to our ability to improve the lives of those around us.
If the paragraph above resonates with you, then you\’re well ahead of the rest of the population. But recognising the value in generating a passive and well diversified income portfolio is only part of the challenge. Creating that passive income; generating the revenue consistently whilst protecting your capital – that\’s the hard part.
Passive income is income paid to you with no active involvement. It is paid to you from assets (investments, business ventures, real estate and so forth) which you own through holdings and shares which pay a cash flow to you. Generating a passive income is something of a safety measure for me – my parents died when I was very young, which took away what many of us take for granted as our most basic and fundamental safety net.
Working to replace that was a decision to reduce the concern so many of us feel about how to pay the bills or wondering about discretionary purchases (new clothes, holidays etc.). As I\’m fortunate to have a job, an investment income also provides me as a self-owned insurance policy; I don\’t need to suffer if I lose my job. Eventually, my passive income will allow my to make tens of thousands of pounds in extra investments each year. It will allow me to support the community around me, through philanthropic causes, financing entrepreneurs and spending more of my time trying to make the world a better place rather than just surviving.
Most crucially, investment income can also be spent without recourse, it has utility through providing freedom. If an asset provides a monthly income, you know you can spend a little more without running out of cash.
Grasping the concept of passive income only gets you half way towards your goal. Turning that concept into a reality is going to take more than just an academic understanding. You need to understand how to turn that academic understanding into a reality.
Fortunately, I\’m in the process of living that next step. Building that income producing portfolio alongside my extensive calendar of working, travelling and studying is a huge challenge, but it\’s one which I feel I\’m getting good at. In today\’s blog, I\’m going to provide six steps you can start today to begin that journey towards earning serious investment revenues. The decision on whether to act on this information is yours alone, but if you\’re serious about creating a passive and well diversified income, I believe these are the steps you need to be taking.
The first thing to understand is that age doesn\’t have to be an inhibitor of investment success. Plenty of people will line up to tell you that you should wait until you\’re older, or give your cash to a professional, but I believe that taking responsibility for your personal financial future is one of the most important decisions you can choose to make.
Step 1: Generating the cash flow
I\’ve already discussed the requirement for acquiring income producing assets. These acquisitions can take a number of forms, but broadly speaking they fall into one of two categories. Firstly, you can buy an asset (making investments, which requires more money than time) or create them, which would mean starting a business venture (which requires more of your time than money). For the purposes of this article, I\’m only going to be exploring investment, which is cash intensive.
Unless you are fortunate enough to have an inheritance, lottery win, or cash generating side business, the first step will be to get a job. Some individuals (myself past included) will be keen to start their own business to provide this, but the reality is that these ventures nearly always take significant amounts of time before they start to generate cash. As you need it now, the quickest way is to get a regular job.
Step 2: Creating and conserving wealth
Now that you have your regular employment, your income should be exceeding your expenses. Maybe you can afford to splash out on that extra Chinese takeaway once month. The second step actually requires avoiding the temptation to increase your outgoings in line with your new income, but to save your extra income to generate a capital float.
Even if it\’s only a small amount, every pound will make the difference. Move the money into an account with no bank card, or put it in a no-access saver; do whatever it takes for you no to spend it. The more you can save, the more capital you\’ll have to invest later.
Step 3: Invest your wealth
Now you have your basic income, and you have your capital to invest, so it\’s time to get started on creating those passive revenue streams. Of course, you may not yet know where or how to invest your funds. As a young person, you probably only have limited information on investment possibilities, but just as with saving, I believe that starting somewhere and taking a risk is better than being totally risk-averse and missing an opportunity.
Personally, I like dividend paying stocks. I follow a defensive dividend investor called John Kingham, and also spend my morning commute researching recommendations and advice from a wide range of sources. The reason I like dividend paying stocks are because;
- If chosen correctly, the assets are generally liquid.
- I can invest in business I understand and which have good regulatory oversight.
- I can enhance my knowledge of investing generally.
Now stock markets are big, and can be complex, and covering the nuances of stock will be covered in other articles on this blog. I\’ll give you a few points here, and you can always browse the other articles if you\’re interested.
First of all, understand that you shouldn\’t view the stock market as \’gambling\’. It\’s a common retort for people that don\’t want to do their research, but simply picking stocks at random is sure to end in misery.
Second of all, try to get a good mix of \’active\’ and \’passive\’ investment funds in the market. The difference between these is simply how they act; an active investment fund is one in which a team will perform investment analysis on a certain set of securities in a bid to out-perform the market, whereas a passive fund is one which simply buys and holds a set of securities (in effect mirroring an index such as the FTSE 100).
Thirdly, make sure you understand the concept of dividend yield. This is a value which indicates the level of annualised income you\’ll receive if you invest in a stock (although this is subject to change). For example, if you see a share which has a dividend yield of 5, this means the income you would receive would equal 5% per year. If you invested £10,000, you would receive £500 a year in passive income, or just over £41 a month.
Obviously, the higher this value is, the more passive income you\’ll earn, although this is subject to company performance, and assumes that the yield is sustainable in the long run. Generally, I try to avoid putting tying too much of my capital into individual share positions (no more than 1 or 2 percent), but if I find a healthy company paying 3-6%, then I\’ll usually invest some of my capital around once a quarter.
It\’s also worth pointing out that high yields can also indicate a poorly performing stock (and usually, therefore, a poorly performing company). If a stock is trading at a significant discount, that can be a great opportunity, but it\’s usually the case that the market accurately evaluates such stocks and they\’re best avoided.
You also need to make sure you\’re carrying out proper research into your prospective investments, although this goes for any investment. In today\’s markets, there are hundreds of commentators, self-proclaimed experts, \’market-leading firms\’ and other news sources that analyse the markets. For me, diversification of information sources is key, but I try to get a good mix of social media commentators and independent bloggers as well as the more traditional sources like the Financial Times.
The vast wealth of information available to you can seem utterly overwhelming at times, and the truth is that this is a complex and difficult field to comprehend. Don\’t let this discourage you from researching and learning in your own way; after a while things start to slot together, and if you make sure you learn from your mistakes, you can only improve your performance over time.
In my opinion, the key to improving your understanding is dedication and consistency. I read investment newsletters and analyses on a nearly daily basis – I download apps and podcasts on my phone, and sign up to as many newsletters as I can find.
I\’m also keen on Real Estate Investment Trusts, another investment which pays a regular income. I\’ve got an article here which goes into more detail on how these work, but all of the previously mentioned tips carry through whatever investments you\’re considering.
Finally, make sure you understand that you are definitely, one hundred percent, going to see the value of your investments fluctuate (which includes significant losses at times) on a daily basis. Depending on your choices, these losses could be terrifying and dramatic to witness, and it might be tempting to sell out of a position to prevent further losses.
The thing to remember is that the \’losses\’ you\’re looking at only become real if you sell the shares. If you hold them and wait for a return, then those falls in the market don\’t affect you. Pursuing a passive income means investing for the long-term, and investing for monthly revenue returns. As long as the companies remain healthy and the income is maintained, you should pause before selling a position.
Step 4: Reinvest your investment income
By this point in the process, you hopefully have purchased a number of income producing investments. As you\’re in the part of the population that has taken action, you\’ll soon be reaping the rewards of your hard work.
As you\’ve made your investments, you now have \’skin in the game\’; a great incentive to continue to enhance your knowledge of investing. If your previous knowledge of investments was lacking, this is going to be a huge turning point for you.
Before long, you\’ll receive your first dividend payment, your first passive income! The next step is to take this payment, and add it to your regular investment payment into another income producing stock. Don\’t be tempted to spend it on that extra Chinese takeaway just yet!
Instead, take that little bit of extra investment capital and add it to your investment portfolio. This is an important step on your road to financial independence.
Step 5: Continue to reinvest your passive income
As the months roll on, you should continue to reinvest your passive income. You\’ll soon notice that what started out as maybe just £100 a month is slowly growing into a more respectable amount.
Month 1: Invest your £100 a month.
Month 2: Invest another £100, alongside the £3 you earned from your last investment.
Month 3: Invest another £100, alongside the £6 from the last two months investments.
Month 4: Invest another £100, plus the £9 from the previous investments.
Do you see how the investment power of your money is growing? You\’ve gone from making a single investment of £100 a month to investing £109 in just 4 months. And you didn\’t even need to work for that extra £9, it was complete passive!
Step 6: Drive investment research and diversification
Now that you\’re earning that passive income, you have a good reason to sit back and enjoy it. But you\’ve not exactly got that safety net I was talking about earlier, and now have two ways you could proceed.
Firstly, you can keep repeating this \’snowball\’ investment strategy. As you progress in your career, your ability to invest larger amounts of capital will increase, and whilst there\’s nothing wrong with this I think there\’s a better way of pursuing success.
Driving research into alternative investments.
Whereas snowball investing is self-explanatory, this choice requires more skill and understanding into investment options that are available to you. Even after a year of researching and investing in the markets, you\’re still not going to be an investment guru (believe me, there are highly qualified experts that mess this stuff up all the time, and they\’ve been going a lot longer than a year!).
Your passive income may be stable and growing, but you\’re unlikely to be making any significant amounts of it. £9 a month sounds great, but what does it actually get you? Three cups of coffee a month? A starter at a good restaurant?
Again – do not despair. There are opportunities out there that can pump out astronomical returns with modest risk, but only sophisticated investors have access to them; you won\’t see them advertised by the branch manager of your local bank. It\’s not that these investments are \’hidden\’, but they often require a combination of creativity and networking to gain access to them.
If you want to drive real passive income, you\’ll need to dedicate your time to seeking out and exploiting these opportunities. Take every chance to learn advanced investment strategies and deal-making techniques. Explore new asset classes, network with great investors and business people, and treat your portfolio like a full time career.
If this all sounds overwhelming, take a moment to step back and re-evaluate what you\’ve just read. I\’m telling you that no matter your age and experience, you can take charge of your financial future and build a passive income portfolio.
Remember; focus on acquiring those assets which generate a regular income, invest your employment income and reinvest the proceeds of both.