Most would agree that diversification plays a big role in the success of one’s personal finances. Spreading out risk is helpful in any environment, but is especially important when times are tough. It is just as important to diversify income as it is investments, because until we achieve financial independence it is income that covers basic life-sustaining expenses such as food and shelter. That brings us to the idea of creating passive income.
I’ve always been a big proponent of developing a side hustle – an additional income-producing endeavor you cultivate along with your full-time job. A side hustle might be related to your full-time job, or it could be something completely separate. In my case, I do very little writing at my full-time gig, and nothing related to personal finances. But past experiences, an interest in writing, and a passion for frugal living came together to form this blog and my side hustle.
What if we took this active-active income model to the next level? What if we used this side hustle to invest and create a third, passive income stream? This would be the ultimate in income diversification, and provide maximum coverage in an income emergency, such as a job layoff or a huge stock market tumble.
I first read about the three-way income model at Money Hacker and thought it was a great concept. I immediately thought about how I could apply it in my own financial life. Keep in mind the difference in active and passive income for these purposes is active income requires me to work actively to generate an income. Passive income continues to grow whether I continue to do work or not. Here are my three current layers of income:
- Active Income #1. My first, and primary, source of income is my full-time job. Until two years ago this was my only source of income. My wife and I recognized that to meet our financial goals of becoming debt free and building a sizable savings fund, we would need to increase our income. After I struck out trying to find part-time employment, and spent a summer mowing lawns in 100-degree temperatures, I came to the conclusion it was time to try something else. Enter the side hustle.
- Active Income #2. In addition to my full-time job, I spend about 20 hours a week working on my blog, and related freelancing opportunities. This makes for some long days, but the per-hour earnings rate is much higher than traditional forms of part time work, such as retail or manual labor. Of course, this wasn’t true in the beginning. I made about $3 per hour the first few months of blogging when time invested yielded very little return.
- Passive Income #1. Creating a passive income stream is the area of this three-way income plan that I need to work on the most. As it is now, we have very little in the way of passive income, save the little bit of interest that accumulates in our online savings account, and the minimal stock dividends that accumulate on the couple stocks and mutual funds we own. Once completely debt free, we’ll be able to afford diverting more of our income to investments, and boost passive income.
Specifically, we plan to use the majority of active income #2 (side hustles) to build a portfolio of income-producing investments. Why? Because I recognize that earnings from active income pursuits are never a sure thing. In my personal example, I could be laid off from my full-time job tomorrow. Advertisers could decide to slash budgets, or some regulatory change could seriously affect my online earnings. I could get sick, or injured, and no longer be able to continue working at a 60-hour per week pace.
For these reasons it makes sense to develop a passive income stream over time to further diversify our sources of income. Early on, the passive income portfolio won’t pay for an extra value meal at McDonalds, but over time our goal will be to grow passive income to the point where it covers all of our required expenses each month.
Passive Income Portfolio Possibilities
What types of investments might make up our passive income portfolio? There are a couple requirements. To be truly passive, the investment has to be a “set it and forget it” type of investment. The simplest form of passive income investment may be a simple savings account. You deposit money, forget about it, and it earns a little bit (very little bit) of interest each month.
As you have higher sums of money to invest you can typically move up in rate of return over a simple savings account. Sticking with deposit accounts for a moment, higher investments in products like money market accounts and CDs will yield higher returns and build our passive income more quickly. A diversified mix of bonds, treasuries and dividend-growth stocks have even higher rates of return (traditionally), but must be spread across a variety of sectors for ultimate diversification.
In addition to financial investments, there are other ways to build a passive income portfolio. Authors of books often earn royalties on copies sold, though the argument could be made that books don’t promote themselves, so the marketing effort required might eliminate the “passive” feature of this investment. In this case, the work is done up front and the residual income that follows could be included in a passive income portfolio.
Over time, we may also use active income to invest in paid-for real estate, and consider rental income and real estate appreciation as passive income. Again, unclogging a toilet at 3:00 in the morning is far from passive, so if you want a totally hands-off real estate investment you will probably need to hire a property manager.
For me, the main benefit of building a passive income from active earnings #2 is that it extends the life of those earnings. If I simply spent them each month on a bigger mortgage, or a car payment, they would be forever gone. Eventually, when my side hustle dwindled away I would have nothing to show for the years of work. This way, passive income will continue to flow long after I quit working for money, guaranteeing financial independence in the years to come.