Rewind the clock to the early 2000s. I was single, but dating my future lovely wife, and working a 9-to-5 job in the defense industry.
I kept my expenses low, my savings were high as a relative percentage of my income, and I was avoiding self-inflicted financial wounds like loading up on a lot of fixed expenses (cars, rent, etc).
I still had an abundance of time, since my girlfriend was still in college, and so I started a blog. The blog would be a precursor to this one in the personal finance world.
The blog would transition into a business, generate income, and I’d put much of that income away into savings. Those savings lived in a taxable brokerage account at Vanguard and invested in their low cost index funds. I would occasionally purchase dividend stocks, especially during the housing and financial crisis, but mostly kept it in Vanguard.
I transitioned into working on the business full-time for a few years before moving on.
All throughout, I invested the profits into other areas that I felt were differentiated from my core business. Savings were put into passive sources of income and kept as cash.
My streams of income
I run several online businesses now (all it takes to start one is a domain, hosting, and maybe incorporation). There are two notable ones. The first is meal plan membership site called $5 Meal Plan that I co-founded with Erin Chase of $5 Dinners. The second is the umbrella of blogs I run, including this one and Scotch Addict. They pay me ordinary income as well as qualified distributions since I’m a partner.
The bulk of my investments are in what we consider the “stock market,” mostly in a variety of Vanguard Index funds. I am paid interest, ordinary and qualified dividends, and will eventually be sold for capital gains. I also have some private placements that are debt and equity instruments which so far just result in interest.
I’ve also made hard money loans to real estate investors (just one individual). They’re simple loans where I am paid interest on a monthly basis.
There are so many more streams than what I’ve listed — I know a lot of people who collect rental income and royalties (like from books or other creative work) — but I don’t have any of those.
The key thing to note in those various streams is how few of them rely on my active participation on a daily basis and how they are fueled from savings. My active participation is in the blogs and $5 Meal Plan. Everything is passive, outside of routine maintenance like updating my net worth record, and none of them would be possible if I didn’t have the savings to invest it.
If you were to look at my tax return for 2015, here is how my AGI broke down:
- Wages — 16% (part active, part passive)
- Interest — 11% (passive)
- Dividends — 21% (passive)
- Capital Gains — 34% (passive)
- Business Income — 18% (part active, part passive)
The vast majority of our income is passive and those funds continue to accumulate (with occasional unrealized “paper” losses as the market moves) without my active participation.
In fact, it’s at the point where the financial benefits of active work no longer have an impact on our net worth. Last year’s wages divided by our net worth was less than 1%.
This transition was one of the biggest personal challenges I faced after “retirement” — a subject I discussed in a post on What They Don’t Tell You About Retiring Early on the great Our Next Life blog. Decoupling work from pay was a huge step.
Not all passive streams are equal
There is only one stream where you bear all of the risk but reap all of the rewards — the stock market. (We can quibble over the use of absolutes but I think you get the point)
In every other case, you bear more of the risk than the rewards you potentially reap because you need to pay someone who is active. If you invest in a business, you take on a lot of risk but you don’t get all of the rewards. Before distributions to shareholders, operators will be paid.
Not only that but in almost all other cases there is the illusion of influence, which is itself a psychological and emotional cost. If you invest in a business that your friend or family member is running, you can see how things can get messy. You have thoughts on how things should be done, they have competing thoughts, if things aren’t going well… we know how this story goes.
That being said, the upside to many of the other options can far exceed the stock market and that balloon payment is very appealing. In five years, I built a website from $0 to seven figures. You cannot do that with the stock market.
The cash flow, leverage, and tax benefits in other passive streams, like real estate, is also very appealing. Donald Trump took a $1 billion tax deduction a few years ago! You cannot do that with the stock market either.
What’s the point …
The point is that wealth accumulation is only possible if you are able to convert active work into income. The higher the rate (pay) the better.
Then avoid self-inflicted financial wounds (you can’t do much about what life throws at you) — then convert those savings into passive income sources.
One final video to cement this idea that the path to wealth is through passive income — it’s a TED talk by Thomas Piketty, author of “Capital in the Twenty-First Century.”
Capital in the Twenty-First Century was published in 2013, it’s very dense with a ton of data, and it focuses on wealth and income inequality.
The core idea is that, over the long term, the rate of return on capital is greater than the rate of economic growth.
This is how wealth becomes concentrated and one of the powerful reasons to save more and have your capital work for you.
If you watched the video, he goes into a discussion about shocks (about 8 minutes in) like bad investments but how they don’t really matter as much if r (rate of return) is greater than g, the rate of economic growth. If r = 5% and g = 1%, then you can lose 80% (the difference) and still be ahead because the return on the remaining 20% has paced with economic growth.
This is a similar idea to my idea of financial gravity. If your savings can grow at a rate that exceeds your own spending, you leave the gravitational pull and now your income is decoupled from your active work.
Now, all that said, if capital (savings) grows faster than the growth of the economy, those with savings will see their wealth grow at a faster rate than those who rely on the growth of their income. While this is not an extension of Piketty’s argument (you can’t take an idea that applies to a population and a whole economy and boil it down to the individual like this), it’s not an unreasonable conclusion to take and apply to your own life. (Piketty does talk about this on an individual level, but says it’s more impactful for billionaires vs. millionaires — though we have limited data into individuals)
If all the talk of passive income and having your money do the work for you didn’t convince you, Piketty’s work (and talk) should put the final nail in that coffin.