Best Passive Income Investments

Passive income

After about the 30th day in a row of working 12+ hour days and eating rubber chicken dinners at our company’s free cafeteria, I decided I had enough.

There was no way I could last for more than five years working in a pressure cooker environment like Wall Street. I became obsessed with generating passive income starting in 1999, the year I graduated from college.

We’ve discussed how to get started building passive income for financial freedom before. Now I’d like to rank the various passive income streams based on risk, return, feasibility, liquidity, and activity.

The rankings are somewhat subjective, but they are born from my own real life experiences attempting to generate multiple types of passive income sources over the past 20 years.

The passive income journey is a long one. But thanks to innovation and technology, the ability to generate meaningful passive income is accelerating!

 

Passive Income Starts With Saving

Generally speaking, it’s much more pleasurable to spend than to save. If saving was easy, we’d never have to read another story again about a multimillionaire who ended up broke.

By far the most important reason to save is so you can have enough money to do what you want, when you want, without anybody telling you what to do. Financial freedom is the best!

Sounds nice right? If only there was a formula or a chart like the 401k by Age chart which gives people guidance on how much to save and for how long in order to reach financial freedom. Unfortunately, saving money is only the first step in building passive income. Figuring out how to properly invest your savings is even more important.

If you can max out your 401k or max out your IRA and then save an additional 20%+ of your after-tax, after-retirement contribution, good things really start to happen.

Ranking Various Passive Income Investments

Below are eight main passive income investments to consider. Each passive income stream will be ranked based on Risk, Return, Feasibility, Liquidity, and Activity. Each criteria will get a score of between 1-10. The higher the score, the better.

  • A Risk Score of 10 means no risk.
  • A Return Score of 1 means the returns are horrible compared to the risk-free rate.
  • A Feasibility score of 10 means everybody can do it.
  • A Liquidity Score of 1 means it’s very difficult to withdraw your money without a massive penalty.
  • An Activity Score of 10 means you can kick back and do nothing to earn income.

To make the ranking as realistic as possible, every score is relative to each other. Furthermore, the return criteria is based off trying to generate $10,000 a year in passive income.

1) Certificate of Deposit (CD) / Money Market

There was a time when CDs would produce a respectable 4%+ yield. Nowadays, you’ll be lucky to find a 5-7 year CD that provides anything above 2.5% The great thing about CDs is that there are no income or net worth minimums to invest, unlike many alternative investments, which require investors to be accredited.

 

Ranking The Best Passive Income Investments

There was no way I could last for more than five years working in a pressure cooker environment like Wall Street. I became obsessed with generating passive income starting in 1999, the year I graduated from college.

We’ve discussed how to get started building passive income for financial freedom before. Now I’d like to rank the various passive income streams based on risk, return, feasibility, liquidity, and activity.

The rankings are somewhat subjective, but they are born from my own real life experiences attempting to generate multiple types of passive income sources over the past 20 years.

The passive income journey is a long one. But thanks to innovation and technology, the ability to generate meaningful passive income is accelerating!

 

Passive Income Starts With Saving

By far the most important reason to save is so you can have enough money to do what you want, when you want, without anybody telling you what to do. Financial freedom is the best!

Sounds nice right? If only there was a formula or a chart like the 401k by Age chart which gives people guidance on how much to save and for how long in order to reach financial freedom. Unfortunately, saving money is only the first step in building passive income. Figuring out how to properly invest your savings is even more important.

If you can max out your 401k or max out your IRA and then save an additional 20%+ of your after-tax, after-retirement contribution, good things really start to happen.

 

Ranking Various Passive Income Investments

Below are eight main passive income investments to consider. Each passive income stream will be ranked based on Risk, Return, Feasibility, Liquidity, and Activity. Each criteria will get a score of between 1-10. The higher the score, the better.

  • A Risk Score of 10 means no risk.
  • A Return Score of 1 means the returns are horrible compared to the risk-free rate.
  • A Feasibility score of 10 means everybody can do it.
  • A Liquidity Score of 1 means it’s very difficult to withdraw your money without a massive penalty.
  • An Activity Score of 10 means you can kick back and do nothing to earn income.

To make the ranking as realistic as possible, every score is relative to each other. Furthermore, the return criteria is based off trying to generate $10,000 a year in passive income.

1) Certificate of Deposit (CD) / Money Market

There was a time when CDs would produce a respectable 4%+ yield. Nowadays, you’ll be lucky to find a 5-7 year CD that provides anything above 2.5% The great thing about CDs is that there are no income or net worth minimums to invest, unlike many alternative investments, which require investors to be accredited.

Anybody can go to their local bank and open up a CD of their desired duration. Furthermore, a CD and money market account are FDIC insured for up to $250,000 per individual, and $500,000 per joint account.

Everybody needs to take advantage of higher short term rates and save more. Just several years ago, money market and CD rates were only 0.1%. Now you can get an online money market account paying 2.2% as of 4Q2019.

Risk: 10 (no risk), Return: 3 (as rates have increased), Feasibility: 10. Liquidity: 6. Activity: 10. Total Score: 39

2) Fixed Income / Bonds

As interest rates have been going down over the past 30 years, bond prices have continued to go up. With the 10-year yield (risk free rate) at roughly 1.75% in 4Q2019, it’s hard to see interest rates declining much further. That said, long term interest rates can stay low for a long time. Just look at Japanese interest rates, which are negative (inflation is higher than nominal interest rate).

Bonds provide a terrific defensive allocation to an investment portfolio, especially during times of uncertainty like we are seeing with the US-China trade wars. If you hold a government bond until maturity, you will get all your coupon payments and principal back. But just like stocks, there are plenty of different types of bond investments to choose from.

Anybody can buy a bond ETF such as IEF (7-10 Year Treasury), MUB (muni bond fund),  or a fixed income fund like PTTRX (Pimco Total Return Fund). You can also buy individual corporate or municipal bonds. Municipal bonds are especially enticing for higher income earners who face a high marginal tax rate. You can also directly buy Treasury bonds through your online brokerage platform.

The main concern is the future of interest rates. If interest rates do go higher, bonds will decline in value, all else being equal. That said, so long as you hold the bond to maturity, you should get your initial principal back along with all the coupon payments if you are buying a highly rated bond e.g. AA.

 

3) Physical Real Estate

Real estate is my favorite asset class to build wealth because it’s easy to understand, provides shelter, and generates income. The only bad thing about owning physical real estate is that it ranks poorly on the passive variable due to tenants and maintenance issues.

Owning your primary residence means you are neutral the real estate market. Renting means you are short the real estate market, and only after buying two or more properties are you actually long real estate. This is why everybody should own their primary residence as soon as they know they want to stay put for 5-10 years. Inflation is too powerful a force to combat.

In order to generate $10,000 in Net Operating Profit After Tax (NOPAT) through a rental property, you must own a $50,000 property with an unheard of 20% net rental yield, a $100,000 property with a rare 10% net rental yield, or a more realistic $200,000 property with a 5% net rental yield.

In expensive cities like San Francisco and New York City, net rental yields can fall as low as 2.5%. This is a sign that there is a lot of liquidity buying property mainly for appreciation and not so much for income generation. This is a riskier proposition than buying property based on rental income.

In inexpensive cities, such as those in the Midwest and South, net rental yields can easily be in the range of 7% – 12%, although appreciation may be slower. I’m personally bullish on the heartland of America real estate and have been actively buying commercial real estate there through real estate crowdfunding and specialty REITs, which we will discuss more below.

 

4) Peer-to-Peer Lending (P2P)

P2P lending started in San Francisco with Lending Club and Prosper in mid-2000. The idea of peer-to-peer lending is to disintermediate banks and help denied borrowers get loans at potentially lower rates compared to the rates of larger financial institutions. What was once a very nascent industry has now grown into a multi-billion dollar business with full regulation.

With a diversified portfolio of 100 or more notes, the leading P2P lenders claim investors can make an annual return between 5% – 7%. The returns used to be higher, but the increased supply of money has brought returns down.

The biggest problem I have with P2P lending is people not paying me back. There’s something that just doesn’t sit right with people breaking their contract obligations.

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