While some investors aim to generate as much wealth as possible over the long haul, many want to use their investments to create income today. This passive income refers to the money you earn from sources such as dividends, interest, and rents. It is the money that your money earns for you and is deposited in your family's bank account whether or not you get out of bed in the morning. The ultimate goal of most investors is to generate enough passive income that they can live a comfortable life upon retirement when they are no longer able to earn a paycheck.
When building an investment portfolio, one trick you can use to stay on course toward financial independence is to measure your success by the amount of passive income you are generating in cold, hard cash each year. When you do this, you can see tangible proof of your progress as checks arrive in the mail or are deposited directly into your bank account.
Creating Passive Income
Imagine you have $10,000 in savings that you want to invest for the long term. You decide to buy 833 shares of General Electric at $12 per share. Let's say the current dividend per share is 12 cents per quarter. That is, every 90 days, you would get a check for about $100. If you have the money directly deposited, at the end of the year, you'd have nearly $400 in cash sitting in the account.
Next year, you save an additional $10,000. You add the $400 in cash from your General Electric dividend, giving you $10,400 in fresh cash. This time, you want to diversify so you buy 74 shares of Johnson and Johnson at just under $140 per share. Let's say its annual dividend is $3.60 per share.
At the end of the second year, you are now generating $400 in passive income from your General Electric dividends and $266 in passive income from your Johnson and Johnson dividends for a grand total of $666.
When you're focused on building passive income, you can largely ignore the fluctuations of the stock market. Instead, your primary aim is to get that passive income figure to grow faster than inflation. It's the difference between thinking like a long-term business owner and a speculator.
A Good Passive Income Portfolio Grows With Time
One of the hallmark traits of a good passive income portfolio is that the cash-generators it holds—whether they are stocks, real estate, equity stakes in private businesses, intellectual property, mineral rights, or anything else—grow each year, so they are throwing off more money than they were the prior year. It is important that the growth rate in cash distributions exceed the inflation rate, so your household income is always expanding, giving you more capital to give away, reinvest, save, or spend.
A good company is one that is able and willing to constantly increase the dividend payout to its owners, so they get ever-growing dividend checks because the underlying operations are somehow superior to the typical organization. Think of a firm like Kraft Foods. No matter how hard competitors try, Oreo Cookies are probably always going to rank among the world's best-selling cookies. Or think of Coca-Cola or Pepsi. No matter how much money you invest in a competitor, it will be virtually impossible to unseat the two soft drink giants from their perch atop the carbonated beverage category.
Likewise, a good real estate investment can support increasing the rent slightly in excess of inflation. You do not want to own struggling, hard businesses. Life is too short to go that route. Your job is to make sure that you end each year with expanded ownership of great, high-quality businesses, and assets that are throwing off more cash than they were 12 months prior. If you focus on these goals, it isn't hard to build wealth over time.
Passive Income Keeps You From Overpaying for Assets
The major advantage of focusing on annual passive income as a metric for success is that it can help protect you from paying too much for your investments. This is a function of basic math.
As prices rise, cash yields fall. An investor focusing on increasing their passive income isn't going to find these low-yield investments nearly as attractive. This provides a countervailing force as optimism sweeps the stock market or real estate market. They have inadvertently protected their family's investments simply by focusing on passive income.
Don't Fall Into Traps
One of the biggest risks for investors focusing on passive income investing is falling into a so-called value trap or dividend trap. As a general rule, if an asset is yielding three or four times more than the 30-year United States Treasury bond, be wary. Most "cheap" assets are cheap for a reason.
In today's world, if you see a dividend of 6%–12% or greater, you are probably walking into one of these traps. It might be a company that had a special one-time dividend from the sale of an asset or the settlement of a lawsuit that won't repeat. It might be a pure-play commodity business structured as a master limited partnership that had record earnings from high prices, which the market knows cannot be sustained. It could be a cyclical business displaying what value investors call the peak earnings trap, meaning its returns look much better at its peak than they ultimately will through a full business cycle.
In any event, be careful. Passive income investing can serve you well, but don't get greedy and overreach for yield. It's all too easy to lose big reaching for just an extra half-point of passive income.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.