There is quite a bit of buzz about passive income with the real estate and stock market values soaring, but do you understand the concept of passive income and how it can help you pursue your financial goals?
Active Versus Passive Income
With active income, you perform tasks to generate revenue. Passive income refers to an investment in which you did not have to put your time and effort other than the initial investment that seeks to generate income.
Real estate, which kicks off rental income to the owner, is a type of passive income. The investor makes an initial investment in the property and the tenant pays rent for the use of the property. This passive rental income is usually taxable. It is often treated differently than earned income by the IRS for tax purposes.
Owning stock in a public or private company that shares profits with shareholders/owners is considered profit-sharing and this dividend would be considered passive income. Stock investing includes risks, including fluctuating prices and loss of principal. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
Owning a certificate of deposit or other types of fixed income, such as a bond, generates interest paid by the borrower to the investor is considered a type of passive income as well. CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity, whereas investing in securities is subject to market risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Why is Passive Income Important?
Have you heard the saying, "Don't put all your eggs into one basket?" That refers to the benefits of diversifying, for if something happened to your basket, and it did not support your eggs, all your eggs would break. Similarly, in investing, if you have your resources spread out into other income-producing investments, then if one sector were not to perform or go away, you would still have additional income being generated. It is less risky. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
So when you are assessing an opportunity and whether you want to invest your money into it, consider these essential characteristics.
- Have an understanding of what investment you are making. A good rule of thumb, if you don't know what the business does or how it makes money from its goods and services, it may not be appropriate for you.
- Is it truly a passive income? If you buy a house in hopes of renting it out, but you are spending most of your time fixing it up, repairing it, cleaning it, finding and managing tenants, then your investment may not indeed be passive. Instead, you are actively working on that investment.
- Understand the downside of your investment, can you lose money? Don't put funds at risk that you cannot afford to lose.
- How long do you need to invest to benefit from your investment? Time can reduce risk, which means demand can fluctuate, influencing what a buyer would pay at any given moment. The longer the time horizon can reduce the risk of investing. According to Fidelity Investments, the S&P 500 index has, on average, recorded a 5% pullback three times a year, a 10% pullback every 16 months, and a 20% dip every seven years.
Passive income and creating multiple sources of income are productive ways to pursue wealth; however, this is provided you spend some time understanding what you are investing in and have vetted the experience and track record of any professional that may be helping you with this passive investment. Spending some time researching and applying common sense will help you navigate the benefits and the potential pitfalls of passive investment.
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.