This article will explore 3 ways to generate passive income. This is income generated through assets, without you having to dedicate your time to earn. Always remember that money is a resource that we can gain, but time is finite for everyone. This could be used to supplement your primary income from a day job, or if done correctly and on a large enough scale, could be sufficient to live off.
The great thing about all of these methods is they require little or no intervention on your part. You can guarantee the income that you receive from them, as well as have the money you invested appreciate over time. In some cases, this capital gains can be a significant rise. I must caveat this video by saying that this is not financial advice and is purely for informational purposes.
Dividends
How can we earn dividends? Simple, through purchasing shares of a company on the stock market. By doing this you are effectively owning a portion of that company, albeit a small one. On a periodic basis, which could be monthly, quarterly, bi-annually or annually, listed companies distribute some of their profits to all of their shareholders in the form of dividends.
What’s great about this is that once you purchase shares within a company, there is no intervention required on your part whatsoever to generate an income, and immediately adds an additional revenue stream. Research has shown that the average millionaire has 7 different income streams.
So long as you hold an investment in the company and it pays out a dividend, you will make money off it. So in theory, if you hold an investment for long enough, the dividend payouts your receive can match and exceed the value of your intial investment. In addition to this, you retain that initial capital value that you invested, which will most likely increase over the duration you hold it.
Historically, investments in the stock market over the long run have yielded significant capital gains. While past performance isn’t necessarily a guarantee of what will happen in the future, there is a lot of value in understanding the ’cause and effect’ relationships that occur when investing, to make sure that you’re aware of what could happen in the market.
This is why investing in the stock market is such a powerful tool for building wealth. If the company does well and increases it’s earnings over time, the price of your shares can increase, giving you capital appreciation on your investment. Conversely, if the company’s performance is on a downward trajectory, the share price can fall and thus giving a loss on your investment.
It’s worth mentioning that company performance can be inhibited by both internal challenges but also several other variables, such as macroeconomic factors, geopolitical tensions and restrictions on trade. This is why trading platforms or institutional investors warn individuals that their capital is at risk, should they decide to invest. Always be mindful that your investment can go down in value, as well as up.
As an investor looking to generate a stable revenue stream over time, we’re most interested in stocks that provide a high, yet reliable dividend payouts. There are many ways we can spot this in a company before investing, this is done by looking at their financial data. One way to determine how much dividend a company will pay out is by looking at previous years dividends. How much did they pay out, if any at all?
This is an essential indicator to whether you will receive a steady stream of income. For example, Royal Dutch Shell has managed to deliver an uninterrupted stream of dividend payouts since World War II (until the 2020 cut). Signs like this can give investors confiendence that dividends are unlikely to be cut or suspended in the near future, with the exception of unprecedented circumstances.
Another factor to look at when looking for an income stock is the dividend yield. This is taking by dividing the dividend payout by the share price to give a percentage yield. While this is a useful tool for calculating an expected dividend, this should not be taken at face value and ignore all other variables.
While a high-yielding stock can indicate that a company pays out an attractive dividend, it can also suggest that the company is facing challenges. Taking the example of Shell again, in 2020 the dividend yield sat at 15%. At a first glance this looks very attractive, however this was due to the massive crash in oil prices in the recent months, leading to a significant sell off of stock. which ultimately led to the first dividend cut since World War II.
Researching the industry a company operates in can sometimes uncover information you as an investor would benefit from, In the case of Shell, as a behemoth of the oil and gas industry will billions of pounds in operating profit each year, it has a robust balance sheet that is fit to sustain the turbulent conditions of the current market and could be seen as an attractive prospect.
The tailwinds for the energy sector, combined with the points mentioned above are why it’s on my personal list of upcoming investments to look at further. There are other factors to consider when investing in a dividend stock, which I have discussed in more detail here.
Index Funds & ETFs
Similar in nature to dividend payouts is the passive income generated by funds. Rather than investing in a single company as you would to receive a dividend, these pool together investor money to form a fund. These funds are comprised of holdings in many companies across many industries. Instead of investing in all of these companies individually, you’re effectively spreading your investment across the entire fund and all the shares within it.
Why is this a good thing? Well, as an investor you’re not exposed to the volatility of a single company and your investment is significantly diversified. This lowers your risk and ensures your capital is secured against a single companies sudden fall in value, should that occur. On the flipside, if a single company in the fund were to suddenly double in value, you would realise less of a gain than if you had invested solely in that company.
Investing tends to offer a risk-reward payoff, how and where you invest is dependant on the amount of risk you want to take on. In the recent market downturn, where many shares saw a fall in value of 70%, there were many funds that recorded losses of only 15 – 18%, with the sigificant fall in shares offset by more stable ones.
Diversification is essential to achieving a balanced portfolio that can weather turbulent conditions, and funds provide part of this to an investor. Ray Dalio, the founder of the largest hedge fund in the world, Bridgewater Associates, explains the pricipal of diversification as the ‘Holy Grail of Investing’. In a nutshell, he suggests that diversification allows investors to achieve the high returns they desire while lowering the associated risk.
He was also the creator of the ‘All Weather Fund’, which gained popularity throughout the industry as a mechanism to maintain stability in capital throughout all environments. This is also now known as achieving ‘risk parity’.
A key difference in funds to holding individual shares is that funds are managed by a third party. They ensure the fund maintains a pre-defined ‘balance in it’s investments and can differ in nature. Some funds are geared towards growth of the stock and seek capital appreciation, while others are ‘High Income’ earners, geared towards shares that once again, pay out higher dividends.
As a result of the ongoing management of a fund, in some cases, there is a cost incurred. A management fee will be deducted from the holdings, typically on an annual basis. It is important to look at this before investing as some funds can incur a hefty management fee.
Personal favourites of mine are the iShares Core FTSE 100, which tracks FTSE 100 companies at a very low cost of 0.07% per year. Another is the HSBC MSCI World fund, which spans over 1,500 companies in 23 different countries at 0.15% per year.
Diversification can be achieved by not only investing in multiple companies, but also across different geographical markets. A downturn in one region can be countered by stability or increased productivity in another. Additionally the conversion of foreign currencies into your local currency and vice versa can provide an added level of diversification.
If you are new to investing and looking to jump in, funds offer an easy and hassle-free way of starting off your investment journey. You’ll get a feel for what it’s like to have capital invested in equities while a professional manages the entire process for you.
Real Estate
The third and final method of generating passive income is through real estate. Unlike the first two methods, real estate is a tangible asset. You can see it, live in it and rent it out to tenants for income. Property is considered one of the safest investments, as it always appreciates over time.
Having a rental property (or multiple) in your portfolio is highly desirable, housing will always be in high demand and there are plenty of prospective tenants to occupy your property. However, investing in a rental property does come with some barriers.
Firstly, you’ll need a larger lump sum of money to invest in real estate than shares or funds. This will be used to put down your deposit on the property. Additionally, in the UK, a ‘buy-to-let’ property or secondary properties other than your main residence incur a stamp duty surchage, further increasing the initial investment required.
You’ll also need to have a good idea of what approximate housing prices are in the area you are looking to invest in to ensure you get a good deal. This can vary due to many factors, primarily location, proximity to major cities, public transport, schools and much more. Local estate agents are great for this as they have invaluable knowledge of the local area. Browing property portals such as Rightmove or Zoopla are also great ways to become more familiar with surrounding areas.
Like shares, there are several calculations investors should weigh up before committing to a rental property. The first is the expected rental yield, by taking the Estimated Rental Value (ERV) and dividing it by the house price to give a percentage yield. The higher the yield, the more attractive the rental prospect.
Similar to dividend yields, this should not be taken alone and other variables should be considered. Another calculation is the Return on Investment (ROI). This should ALWAYS be taken into consideration before investing in property. This is calculated by taking the estimated Net Profit of owning an renting the property and dividing it by the total investment made into the property.
This total investment should include all investment, from the deposit to stamp duty, to mortgage fees, furnishing and others. The higher the ROI, the better the investment. Knowing what your costs are before investing and budgeting accordingly is essential to investing in real estate.
If the property cash flows negatively, meaning the costs incurred are greater than the revenue it generates through renting it, then your disposable income will decrease as a result of owning the property, and you would have been better off not investing in it at all if passive income generation was the objective in the first place.
Another element to be mindful of is that rental properties can go through void periods. This is when there is no tenant living in the property and you are subsequently not generating any income from it. You will however still incur the costs of owning the property such as mortgage fees and any overheads.
Estimating a void period between tenants and factoring this into your calculations can help you envisage what your projected cash flows may look like. Managing the process of looking for prospective tenants, interviewing them, screening and moving them in can be time consuming. If you want to take a more ‘hands off’ approach to owning real estate, you can onboard a property manager to do this for you.
They will manage the property, any maintenance and the tenants for a management fee. This takes the pressure of you but will also lower your margins. And there you have it, three ways to earn passive income.
