Passive Income Investment – What, Why and How?

Passive income investment means that you make the investments once and then simply keep them, potentially for life. Investing is one of the most accessible ways available of generating passive income (cash-flow) in the form of interest, dividends or coupons.

No one can live of assets, we all need cash-flow to pay our bills and over the last decade numerous blogs have appeared on the topic of passive income investment.

Living of the income generated from financial investments?

As we are approaching almost a decade of good performance in the financial markets, more and more people seem to be interested in using the financial markets to generate passive income. These are single individuals just as much as couples and families who want to have more time to do what they are passionate about instead of trading their time for money all their lives (meaning working for someone else).

There are many different ways of making this happen but the easiest way for anyone is to lower ones expenses. The alternative is to increase the income and save more or a combination of the two. The key thing for these families is to save and invest a lot now and continue doing that for a number of years and then never have to work ever again as they will be living of the income generated from their investments.

They know how much money they need for Financial Security, which we define as having enough income (cash-flow) to pay for housing, utilities, transportation and food, i.e. the basics. Many of them also know how much they need to be Financially Independent, which equals the amount they need to continue living their current lifestyle. To become financially free one of course needs to know how much cash is needed every month and then find a way of generating that income, ideally passively.

What is passive income investment?

The strategy of passive income investment means investing in income generating securities like bonds, stocks and preferred stocks that pay “high” dividends. These investors normally target dividends or coupons yielding more than 4% per year. They focus their savings on these investments, spreading the risks to various extent with the ultimate goal of creating enough monthly cash-flow from these dividends and coupons to live from it. When they reach that point, they don’t have to work anymore because the money will still keep coming in passively (as long as their investments pay dividends)!

The goal of becoming Financially Independent this way might seem far-fetched but those who start on this path normally lower their living expenses and save 30-70% of their income. They want to become Financially Independent fast and they have made this a clear priority in their lives. They have their goal and strategy set and have started executing by taking deliberate action (reducing costs and investing a lot).

Those who do this have a clear goal, they don’t want to work for the rest of their lives and are willing to do the work now and for a number of years to come. The ultimate goal might be to be financially independent within ten years and considering that many (if not most of us) will live closer to 100 years, it is a small price to pay. When they commit to this, they will of course completely retrain their way of thinking and behaving around money (another proof that one can change one’s money mindset).

It might seem daunting to be this radical but it is just a priority in life which some choose to make. An alternative way is of course to be less “extreme” but to start taking some measurements and start to save and invest more. The goal then might be to improve the cash-flow as retired which is a great starting point. You might not get to a level where you generate X thousands of dollars in passive income investment every month but everything counts and we can all only start where we currently stand. Even a few hundred dollars per month will make a significant impact to many retirees, if you don’t believe this, I recommend you ask a couple of them…

Why doing it?

I presume there are no question marks as to why people would want more cash-flow. It’s pretty obvious that they want to enhance their quality of life. Though there are various reasons why one would focus on passive income investment like cash-flow generating securities and this can be discussed at length. In this post I am just painting the general picture as there are numerous ways of how to go about it and it is all individual.

A common focus for many of these investors is to invest in big brands that have been around for a long time, paid dividends (or coupons) every year, have good cash-flows, low debt and a good market outlook. These “prerequisites” will do for most investors as they then expect that these companies will keep on paying dividends in the future too. These investors are hoping that the valuation of these companies will not fluctuate that much over the business cycle and even if they do, it’s not a big deal as they don’t intend to sell to make a profit. The goal is to always stay invested and enjoy the dividends (cash-flow) but at the same time they also hope for the price of the stock to increase as well! If the company does well, the performance of the stock is good and the dividend hopefully increases. So focus is cash-flow but of course they want their investments to increase in value. If on top of this, the company tends to increase their dividends, that might even be seen as some inflation protection (rising prices).

Where we currently are in the business cycle and after almost a decade of positive stock markets, it makes it harder to find these companies and at “decent valuations”. Since I wrote this a few months back, we have seen a significant increase in volatility so there might actually be more decently valued stocks around when this is published.

Warren Buffett is famous for the concept of “value investing” and many of the above comments are in line with what one would call “value investing” though it is becoming harder and harder to find “value stocks”. Mr Buffett has been exceptionally successful in this and many investors using the strategy of passive income investment are looking at investing like Mr Buffett.

One difference is that Mr Buffet always wants to re-invest any dividends in the market immediately as he understands the importance of compounding (interest on interest). The investors I mention above are making similar kinds of investments as Mr Buffett but for a different reason, they want the cash-flow to cover their expenses. If they don’t, they normally re-invest the dividends but that has to be done manually if one buys single stocks compared to buying a fund where dividends are normally automatically re-invested.

There are many reasons to be aiming for passive income investment but there is a clear group of investors who wants to build a big enough portfolio so that the dividends they get can fund their lifestyle and that is why they do it.

A glimpse into how I use this strategy

I use the strategy of passive income investment for part of my investments since not all my investments are in securities. I partially use this strategy in my portfolio for the cash-flow but I also believe that these kinds of “value” companies over time will be a good investment with relatively low volatility (fluctuations in value compared to other stocks). I am using a variation of the income investing strategy which I find suits me and my interest, risk profile etc.

The first things I personally look for before investing:

I do look at individual stocks and the key steps I take prior to making an investment in this case are a bit different (more time spent analyzing) compared to when I invest in an Exchange Traded Fund (ETF). However, considering ETFs is the first step I would recommend anyone to take (for the sake of simplicity).
I look at a list of high dividend paying stocks using a site like: www.dividend.com or by looking at fact sheets from high yielding funds and ETFs to get a sense of what they invest in for their dividends. I will rarely look at anything above 8% yield (if the yield is that high, there is normally a reason why the market is pricing the stock so low…) as the risk should be much higher in that kind of investment compared to something yielding 5%.
I then use my 10 Key Questions I always ask before making an investment. Upon having gone through those I make a decision based on my view of the market and sector in combination with the look of my current portfolio to make sure the particular investment adds value and not more risk (ideally I should get more diversification as well as more dividends).
High dividend and consistency (the longer history the better).
Ideally consistency in increased dividend every year (protection against inflation).
I like companies in sectors with high barriers to enter (less competition).
I like companies with reasonable valuations (I look at a number of ratios).
I prefer companies with low (or no) debt (leverage), if they do have leverage I always check their ability to pay their interest, especially if I think interest rates are about to increase and they have loans or outstanding bonds with floating (variable) rate. Interest expense is cash out from the company and if they have to pay out more of that, there is less left to pay to investors, simple as that.
I like companies in defensive sectors with low correlation (should mean lower risk over time) to the overall stock market (if the overall market goes down with 10% I don’t want my portfolio to go down with 10%, hence the importance of low correlation and a diversified portfolio).

Some of the securities I hold and why

I have handpicked a variety of stocks from different sectors but I do have a bit of overweight towards property companies for various reasons but not only Real Estate Investment Trusts (REITs). I want to keep the individual weights to a maximum of 2% unless it’s an investment company (because of the diversification benefits from an investment company).

I also own credit and bond funds, mainly focusing on High Yield (higher yielding debt instrument but without the potential upside one has when investing in stocks).

Besides that I invest in loans, mainly corporate loans which means they pay interest to me on their loans and this is providing me with cash-flow.

Preferred stock is another interesting investment. You don’t have the upside as in a normal stock but you have a high dividend which you receive before any dividends are paid to the ordinary stock holders (alwyas read the fine print though before buying a preferred stock). There is no real upside in terms of performance, hence a higher dividend is required by investors (around 5-10%). A bit risky in an environment with increasing interest rates as preferred stocks normally fall when interest rates rises (your coupon is fixed so compared to other investments where interest is increasing these stocks would seem less appealing).

The above variety combined with different sectors and geographical areas are giving me a pretty good diversification (or so I think/hope). To give you some more color, below are a few of my holdings, starting with Exchange Traded Funds and then followed by single stocks:

Ishares Core High Dividend – Broad US dividend focus and instant diversification
Ishares European Property Yield – European properties for yield and stability
Xact Högutdelande – Nordic high dividend which is easy for me as a Swede:)
Ishares Total S&P TSX High Dividend – Canadian stocks, diversification and dividends
Johnson & Johnson – Global consumer goods (we will always need these products)
Arcadian Timer – a forest company in Canada
Ladder Capital Corp – A financial company focusing on loans in the US
Brookfiend Renewable Energy partners – Renewable Energy, big firm and high div
Omega Healthcare – US REIT in the health care sector focused on dividends
Fortum – European Energy company which should be a “defensive” investment
Akelius preference stock – Large property owner, low leverage and high dividend (bought back by the company in dec 2019 but own similar ones)
Axfood – Food retailer with high div, we always need to eat:)
Investor – Investment company, dividend and growth

This was just to give you a glimpse and also a very short comment on some of the investments I have but again, all investments are individual and have to be in line with the investment and risk profile of the investor.

An easy way to get started with passive income investment

This is just one way of easily getting started with passive income investment. There are numerous different ways of doing it and one has to find a way which suits the individual need and investment profile. Before making any financial investments, one should always consult a financial fiduciary to make sure it is suitable.

The purpose of this example is to show how easy it is to add some cash-flow, especially if one is looking over the longer term (+10 years) as the total returns (dividend and performance) and in particular valuations of the investments will vary over time.

These are the steps one can take to get into passive income investment:

Decide your Financial Security number and write it down in your Goal Setting Sheet (you’ll find it on our Visions & Goals Section) which refers to the cash-flow you need to get every month to cover you necessities.
Learn more about this strategy by browsing sites like these for inspiration: www.thebalance.com, www.suredividend.com, www.thesimpledollar.com (or just google dividend investors). Only use this for inspiration and to get an idea of what others are doing. DO NOT simply copy someone else, you have to make your decisions based on your personal situation!
Log on to your online bank or online broker and open a new investment account (remember to make sure you keep the costs at a bare minimum and if you don’t know ask a friend who knows what to look for in your country and who has done it successfully!).
Understand that investments have risks and make sure you are ok with any and all of the risks you take!
Decide how you want to split your investments so that they suit you and if you are not keen on finding and evaluating single stocks, maybe just have a look at a large Exchange Traded Funds (ETFs) provider like: www.vanguard.com and search for High Dividend and you will find a list of different alternatives like the Vanguard High Dividend ETF.
By investing in an ETF you get instant diversification as the fund invests in many securities, this specific example has 405 holdings!
Have a look at their top ten holdings (do that for several high dividend funds) and you will soon get a good idea of what the most “popular” high yielding securities are. In this specific fund, these are the ones and I am pretty sure you are familiar with most of them:
Once the investment account has been set up I would automate a monthly transfer to that account with the amount I have decided to invest every month.
If you decide to make monthly investments, make sure you pay very low commission for every trade OR find a mutual fund with very low management fees (like 0,20% per year) and NO commission (investing 100 USD per month and being charged 10 USD commission is a bad idea!!).
When you have decided what to invest in just double check that the monthly transfer and purchases are happening, just like when you have a direct debit on your electricity bill.
The more you invest, the faster you will get to your desired goal and consistency is key so don’t use the money you have invested as you should have other ”buckets” to use when you need money (for more info on our Bucket System, check out the post on that topic in the links below).

This is really how simple it is to get started with the strategy of passive income investment. Again there are numerous ways and variations of generating cash-flow and you have to find your way. Although by just getting started (doesn’t matter how small), it will add up and by investing in ETFs or other low-cost investments you get instant diversification (spreading your risk amongst many different securities). Low cost and risk diversification is key, especially if you don’t want to spend a lot of time analyzing different investments individually, nor constantly be checking your account and the performance.

Of course you have to be aware of the fact that if you invest in financial securities, there is risk and you could possibly lose all your money (although extremely unlikely if you invest in an ETF with 400 securities). This is why it is so important to invest according to your risk and investment profile and only invest money you can afford to lose, spread your risk and invest over the very long-term.

The best (and only way) to make things happen is by taking action. It doesn’t matter how much knowledge one has, without action, there will be no results and remember that everything counts so just make sure you take that first step now, even if it is just 20 USD per month!

This might be one of the easiest way of generating passive income investment and if you read some of our other posts, you will both get more information and inspiration on how you can start your journey towards a life on your terms. How fast it will happen, depends on how bad you want it and on how much you are willing to compromise today to live the life you truly want for the rest of your life, knowing you have the cash-flow to pay for that lifestyle.

Best of luck with your passive income investment strategy!