What Many People Misunderstand About Passive Income

There’s no such thing as truly passive income.

It’s like getting rich quick or a free lunch, they sound great but they’re figments of your imagination. It’s a myth. And a dangerous one.

You can build up streams of passive income but if you think it’s some kind of Ronco “set it and forget it,” you’ll be very disappointed or very ripped off (and sometimes both).

All passive income sources will require work, usually a large amount of research up front followed by a sizable amount every year. It may also require you to do some real work too.

It can be financially lucrative but it’s not without work.

What is Passive Income?

You’ll see a lot of definitions but the basic idea is that it’s income that you don’t have to “actively” earn.

The IRS has a definition for “Passive Activities,” which is a good enough definition for passive income sources. Passive activities are those “trade or business activities in which you don’t materially participate.” This means you are not “involved in the operation of the activity on a regular, continuous, and substantial basis.”

They offer some exceptions where you are materially participating but they still consider it passive, such as real estate when you aren’t a real estate professional.

This is distinction important for tax purposes because you can offset passive income with passive losses. There is a limit to how much in passive losses you can claim against your active income.

This distinction is less important for how most of us think about passive income – we want money rolling in without having to work for it.

Why Is Passive Income Misunderstood?

Passive income is misunderstood because no source of income can be attained with zero work. The closest you can get to this is putting all of your money into an index fund and collecting the dividends. You could make it nearly passive by making the contributions automatic.

But you still have to monitor it on a regular basis.

I check my investment accounts once a month when I update our net worth spreadsheet. I look to make adjustments on an annual basis, usually to give it a rebalance if the allocation is a bit too out of sync with my target. (I try to adjust it with regular contributions rather than trigger taxable events through buying and selling)

I don’t mess with it often but it’s not completely passive either. It’ll appreciate or depreciate no matter what I do but I still need to keep an eye on it.

But when people think about passive income, they aren’t talking about the stock market. Everyone knows about that and it’s not the sexy topic. For passive income, they’re often talking about other sources of passive income.

If you notice, they come in two major categories:

• Invest in someone else doing the work (real estate, lender, buy a business)
• Invest time into a project and collect (write a book, build a website)

Investing in Someone Else

This requires a lot of research. When you invest in an index fund, you’re leaning on the expertise of others and the size of the market. We know index funds are good investments because we have a history of performance, a trust in the company running it (we don’t wonder if Vanguard or Fidelity or others are legit), and lean on other assumptions we have about them.

When you invest in something novel, such as a crowdfunded real estate, you have to do more research. Are we looking at the future of real estate investing or is this something closer to peer-to-peer lending?

Jeff at Good Financial Cents documented his returns from Fundrise and even through a challenging period (the post covered a period through April 2021), it offered solid returns. It’s real estate (well understood) even if it’s done in a way that’s not new (it’s a privately held REIT) but “mass” marketed to individual investors (which is relatively new).

Do you remember when peer to peer lending platforms first emerged? Companies like Lending Club and Prosper offered the ability to “invest” in loans to individuals. You became a lender, at $10 and $20 increments, to a lot of borrowers and tried to build up a portfolio with a blended interest rate that made sense for that level of risk. Sounds great in theory, but in practice we discover the risks of lending.

In the first few years of peer to peer lending, default rates were far higher than anticipated and many people saw much lower returns and even losses. Jonathan from My Money Blog shared his LendingClub returns and they were… lackluster. I don’t know the state of that world today because I never got involved because they were offered to residents of Maryland due to securities laws (as far as I recall). Then again, not many folks are talking about it now so I suspect it’s not as appealing.

Even if someone approaches you with something not novel, say a regular real estate investment opportunity, it may be novel to you. I’ve invested in a few real estate projects and needed to learn a lot about how they were structured, how they compared to similar investments, and how much faith I had in the operator (and more).

The point is: None of these sources are passive – you have to do the work or you might get ripped off.

When I used to angel invest, I didn’t do the work. I should say – I didn’t do enough work. I thought I was doing enough research but, in looking back, I didn’t do nearly enough. I didn’t know what I didn’t know and it hurt me (financially). Fortunately it wasn’t for a lot of money, I was still skeptical enough and dipping my toe, but losing money always hurts.

The research required for analyzing a real estate offering isn’t as challenging as many other markets. Real estate is a relatively well understood investment. You can find comparable investments to give you a sense of what’s “typical.” You can find people who have done this before and ask them for advice.

What if a friend wanted to open a business and looked to you to invest? That’s different.

What if it was a brew pub where they made their own beer? Good investment or not?

I was lucky in that we know a family that runs a local brewery and there’s also Leif from Physician on FIRE’s, who has invested in a brewery. I chatted with him about it when a friend approached me!

Can you imagine how much research you’d need to do to really understand that business? It’s far more than you expect no matter how much beer you like to drink. 🙂

Investing Your Time

If you don’t want to give your money to someone else, what if you invested a bit of time to build up a future stream of income? With the power of the internet, you can build an asset that generates cash flow for many years.

Perhaps you want to write an ebook or start a blog that generates advertising income? Great! But both require effort with no guarantee of a payoff.

Both of those will require research too, especially if you are doing this for money and not as a fun hobby. You don’t want to spend a tremendous amount of time building something that no one wants.

And even if you do build something that can make money while you sleep, nothing makes money forever unless you add to it. Build on top of it. A blog that has no new content is a blog that slowly slides into obscurity.

One prime example of this is writing novels. I know several self-published authors who have a catalog of books on Amazon. At first glance, it appears that all it takes is the ability to write a compelling story that others want to read.

When you look behind the scenes, it’s far more complicated. You want those readers to get to your website and sign up for your email list, so you can promote your other books. You also want those readers to tell their friends about your work. You want to adjust the pricing of your books so sell more and potentially appear higher on the bestseller lists, which helps you sell more books.

This is all on top of being or becoming a good writer of stories people want to read. (and be willing to pay for it!)

Being a good writer is simply the start, getting good at promotion is required, and none of this is intuitive. You only see this by talking to other writers or buying other writers’ books and seeing their flow and structure. It requires you to do research and study – which takes even more time.

You may sell books while you sleep but you better be working when you’re awake. 🙂

And the worst part is that while this requires a lot of time, it can result in zero sales.

It will feel like you’re swinging a hammer at a brick wall. You swing and swing and swing. The wall doesn’t budge. Then, one day, you swing and it cracks. Then it breaks. It wasn’t that last strike but all the swings before it. But you won’t know which swing breaks through so you have to keep swinging.

It’s hard to keep going when you don’t see any changes, but that’s how these games work.

Real Passive Income Requires Work

When you think about passive income, it’s important to recognize it for what it is – work. You might be able to do it on weekends and at night, but it still requires work. It may earn money while you are doing other things but it still requires work.

Passive income is not passive. Passive income requires work. Sometimes a lot of work.

Passive income does offer one benefit that that your full-time job doesn’t – it decouples the effort from the rewards. When you work a 9-to-5 job, you get paid when you show up. If you stop showing up, your employer will stop paying you.

When people think about passive income, they focus on how they can earn money without working. While that may be true, it’s inaccurate. They are being paid for work they already did, they’re simply earning it when they’re doing other things.

When you invest in the stock market, you do the research up front and reap the rewards later. Sometimes many months, years, or decades later.

The other misunderstanding is that effort leads to rewards. Effort doesn’t always lead to rewards. It can lead to losses, sometimes massive losses.

The key idea is that the effort can lead to outsized rewards too. You can start a blog from scratch and sell it for millions of dollars. You can’t get rich quick but you can get rich quicker than you expect (and poorer too).

So when you think about passive income, remember that it’s about decoupling effort from rewards.

It’s not free money when you sleep.