After about the 30th day in a row of working 12+ hour days and eating rubber chicken dinners at the free cafeteria down at 85 Broad Street, 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.
We’ve discussed how to get started building passive income for financial freedom in a previous post. Now I’d like to rank the various passive income streams based on risk, return, and feasibility. 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 16 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.
I’ve already touched upon one reason to save: to buy a property in order to expand and make a profit. Let’s talk about the most important reason to save: to have enough money to do what you want, when you want, without anybody telling you what to do.
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 what to do with your savings is just as 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. If one is looking for earlier financial independence, such as retiring in their 40s or early 50s, it may be a good idea to skew towards more after-tax savings and investments given one has to wait until 59.5 to withdraw from their 401k or IRA penalty-free.
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) Certificates 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 is FDIC insured for up to $250,000 per individual, and $500,000 per joint account.
Interestingly, many online money market accounts are paying higher than CDs right now because the yield curve is flat. For example, CIT Bank has an excellent 2.45% money market account rate as of 1H2019, which is the highest I see online today.
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%.
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 2.75%, 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. 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. The main concern is the future of interest rates. If interest rates do go higher, bonds will decline in value, all else being equal.
I’ve personally been accumulating a large position of California municipal bonds whenever the 10-year yield breaches 3%. The tax-free yields range from 3.6% – 4.2% for a 20-year duration, equivalent to a gross yield of 5% – 5.5%.
Risk: 8, Return: 5, Feasibility: 10, Liquidity: 8. Activity: 9. Total Score: 40
3) Physical Real Estate
For those willing to take on the task of managing a property, real estate can be a powerful semi-passive income stream due to the combination of rental and principal value appreciation. But to generate passive income from real estate, you either have to rent out a room in your house, rent out your entire house and rent elsewhere (seems counterproductive), or buy a rental property.
It’s important to realize that 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.
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. When I say net rental yield, I’m talking about rental income minus all expenses, including a mortgage, operating expenses, insurance, and property taxes.
In expensive cities like San Francisco and New York City, net rental yields can fall as low as 2%. This is a sign that there is a lot of liquidity buying property for property 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, net rental yields can easily be in the range of 8% – 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.
Risk: 5, Return: 8, Feasibility: 7. Liquidity: 3. Activity: 6. Total Score: 29
4) Peer-to-Peer Lending (P2P)
P2P lending started in San Francisco with Lending Club 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.
Lending Club went public in 2014 and is now worth about $1.7B. They advertise P2P lending returns of over 7% for well-diversified portfolios of over 100 notes. I’ve personally been able to achieve a 7.4% annual return over the past two years in a completely passive way by investing in A and AA notes. Others have achieved a 10% annual return through relatively minimum effort.
To achieve $10,000 in annual passive income through P2P at a 7% rate, you need to invest $142,800 in hundreds of high-grade notes. The higher the interest rate, the higher the risk. P2P lending has taken me the longest to get comfortable with because I really dislike the idea of people not paying me back (breaking their honor).
Risk: 5, Return: 6, Feasibility: 9. Liquidity: 6. Activity: 8. Total Score: 34
5) Dividend Investing
Investing in large cap dividend companies is one of the best ways to build passive income. The “Dividend Aristocrats” are a list of blue chip companies in the S&P 500 that have demonstrated a consistent increase in dividend payouts over the years.
Let’s say a company earns $1 a share and pays out 75 cents in the form of a dividend. That’s a 75% dividend payout ratio. Let’s say the next year the company earns $2 a share and pays out $1 in the form of dividends. Although the dividend payout ratio declines to 50%, due the company wanting to spend more CAPEX on expansion, at least the absolute dividend amount increases.
Dividend stocks tend to be more mature companies that are past their high growth stage. Utilities, telecoms, and financial sectors tend to make up the majority of dividend paying companies. Tech, Internet, and biotech, on the other hand, tend not to pay any dividends because they are reinvesting most of their retained earnings back into their company for growth.
To achieve $10,000 in annual passive income at the S&P 500’s ~2% dividend yield, you would need to invest roughly $500,000. Or instead of investing in the S&P 500 index, you could invest $183,800 into AT&T stock given its 5.44% estimated dividend yield.
One of the easiest ways to get exposure to dividend stocks is to buy ETFs like DVY, VYM, and NOBL or index funds. You can also pay an algorithmic advisor like Wealthfront to automatically invest your money for you at a low fee. In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market.
Wealthfront charges $0 in fees for the first $5,000 and only 0.25% for any money over $10,000. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation. The key is to invest regularly.
Risk: 6, Return: 7, Feasibility: 10. Liquidity: 8. Activity: 10. Total Score: 41
6) Private Equity Investing
Private equity investing can be a tremendous source of passive income with the right investments. If you find the next Uber, the returns will blow every single other passive income investment out of the water. But of course, finding the next Uber is a tough task since most private companies fail.
The most liquid of the private investments are investing in equity or credit hedge funds, real estate funds, and private company funds. There will usually be 6 month – 3 year lockup periods. The least liquid of the private investments are when you invest directly into private companies yourself. You might not be able to get your money out for 5-10 years, depending on the success of the company and upcoming liquidity events.
Access to private investments are restricted to accredited investors, which is why the Feasibility Score is only a 4. But the Activity Score is a 10, because you can’t do anything even if you wanted to. You’re investing for the long term. The Risk and Return score greatly depends on your investing acumen and access.
Gaining $10,000 a year in private equity investing is difficult to quantify unless you are investing in a real estate or fixed income fund. Such funds generally target 8-15% annual returns, which equates to a need for $83,000 – $125,000 in capital.
Risk: 4. Return: 7. Feasibility: 4. Liquidity: 2. Activity: 10. Total Score 27
7) Creating Your Own Products
If you’re a creative person, you might be able to produce a product that’s able to generate a steady flow of passive income for years to come. At the extreme, Michael Jackson, makes more dead than alive due to the royalties his estate makes from all the songs he produced in his career – an estimated $140 million in 2014 according to Forbes.
Of course it’s unlikely any one of us will replicate the genius of Michael Jackson, but you could produce your own eBook, e-course, award-winning photo, or articles online to create your own slice of passive income.
My esteemed marketing colleagues initially balked at the idea of creating products that generate royalties, so I can understand how creating something from nothing might be daunting for those who aren’t even in creative roles. However, realize there is this enormous world out there of photographers, bloggers, artists, and podcasters who are making a passive income thanks to the Internet.
In 2012, even I wrote a 150-page eBook about severance package negotiations that still regularly sells about ~40 copies a month at $85 each without any effort. In order to generate $3,400 a month or $40,800 a year in passive income as I do now, I would need to invest $1,020,000 in something that generates a 4% yield. To earn $10,000 a year in passive income would therefore need roughly $250,000 in capital.
Ask yourself how many hours a week do you spend sitting in silence, coming up with an idea and working on your idea? We’re so busy with our jobs that our childhood creativity sadly vanishes at some point in our lives. There are food bloggers who clear over $15,000 a month. There are lifestyle bloggers who make over $10,000 a month while living in Thailand. And there are even personal finance bloggers who’ve sold their sites for multi-millions.
Leveraging the internet to create, connect, and sell is something every creative person should attempt to do. The only risk is lost time and a wounded ego. You can start a site like mine for as little as $2.95 a month with Bluehost and go from there. They give you a free domain name for a year. Forget all the add-ons. Not a day goes by that I’m not grateful for my site.
I truly believe generating $10,000 a year online can be done by anybody who is willing to dedicate at least two years to their online endeavors. Here is a snapshot of what a real blogger makes through his website and because of his website. Roughly $150,000 a year is semi-passive income followed by another $186,000 a year in active income found through his site. Check out my guide on how to start your own blog here.
Risk: 10, Return: 9, Feasibility: 7, Liquidity: 8, Activity: 9. Total Score: 43
8) Real Estate Crowdsourcing
I’m a big fan of real estate crowdsourcing, which basically allows individuals to buy a piece of an investment project or lending money to an investment manager somewhere around the country for a return. Owning physical real estate is great, but it’s like going all-in on one asset in a particular location with leverage.
Real estate crowdsourcing allows you to surgically invest as little as $1,000 into a residential or commercial real estate project for potentially 8 – 13% annual returns based off historical data. Such returns are much better than the average private equity, CD, bond market, P2P lending, and dividend investing returns. With P2P lending, borrowers can sometimes default and leave you with nothing. At least with real estate crowdsource investing, there’s a physical asset that’s backing your investment.
For those of you who don’t want to come up with a $300,000 downpayment and a $1,200,000 mortgage to buy the median home in an expensive coastal city like SF or NYC, who don’t want to deal with tenants or remodeling, and who wants to not do any work after the investment is made, check out Fundrise. They are my favorite real estate crowdsourcing company founded in 2012 and based in Washington DC. They are pioneers in the eREIT product offering and they’re raising an Opportunity Fund to take advantage of new tax favorable laws.
In mid-2017, I sold my San Francisco rental property for 30X annual gross rent and reinvested $500,000 of the proceeds in real estate crowdfunding. I’m leveraging technology to invest in lower valuation properties with higher net rental yields in the heartland of America. It feels good to earn income passively now and not have to deal with tenants.
Risk: 7, Return: 8, Feasibility: 10, Liquidity: 7, Activity: 10. Total Score: 42
Passive Income Ranking Review
All eight passive income investments are good ideas if you can execute them. Some are just better than others. Based on my five factor ranking system, Creating Your Own Products, Real Estate Crowdsourcing and Dividend Investing are the best passive income investments for most people.
The biggest surprise is real estate being second to last on my Passive Income Ranking List because I’ve written that real estate is my favorite investment class to build wealth.
Physical real estate doesn’t stack up well against the other passive income sources due to the lack of liquidity and constant maintenance of tenants and property. The returns can be huge due to rising rental income AND principal over time, much like dividend investing. If you are a “proactive passive income earner” like myself, then real estate is great.
Finally, I imagine the biggest debate with my ranking is Creating Your Own Product as the #1 passive income source. If most people have never created their own product, then it’s easy to give it a thumbs down.
There won’t be much complaint about Private Equity Investing being in last place because most people are not accredited investors. But given I believe that plenty of people can create their own product if they try, pushback is inevitable because a lot of people simply don’t try!
Start Investing Early And Often
Enthusiasm for work is strongest when you are young and have very little money. After four years of high school, followed by another four years of college, work sounds like an exciting adventure! But after a while, your job can begin to beat you down.
Perhaps a coworker purposefully tries to make your life miserable because they resent your success. Maybe you get passed over for a promotion and a raise because you weren’t vocal enough about your abilities, and mistakenly thought you worked in a meritocracy. Whatever the case may be, you will eventually tire.
This is why it is important to take action, while you still have the energy. With interest rates at rock bottom levels, building passive income will take a lot of effort and patience. The sooner you get started, the better!
Here’s my latest passive income streams that took 19 years to build. I don’t include all my online income because generating income beyond my severance negotiation book takes work.
Wealth Building Recommendation
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Updated for 2019 and beyond. The bull market is showing signs of fatigue. You’ve got to be on top of your finances more than ever before.