In this guide, we’ll examine what passive income is exactly, the five popular methods to earn passive income, how they work, how much you can expect to make, and limitations to consider.
Passive income definition
There are two primary types of income: passive and active. Active income is exchanging time for money, where your earnings are directly related to how much time you work. Passive income, on the other hand, is a way of making money without active participation and isn’t directly linked to how many hours you’ve worked.
The opportunities and requirements differ depending on the passive income type. Still, they generally call for an up-front investment that continually generates income flows without requiring the investor to monitor or actively adjust their holdings.
This guide will inspect the five best strategies for passive income.
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#1 Dividend investing
Dividend investing is a method of buying shares that pay dividends to receive a regular income stream from your investments and is one of the easiest ways for investors to generate passive income.
Dividends are payments that a corporation (typically publically traded companies) offers to shareholders. When an investor owns stocks that pay dividends, they are getting a share of the company’s profits.
Many investors expect regular payments as compensation for holding their money in the company, allowing them to secure a stream of income on top of any growth in their portfolio as its stocks or other holdings gain value (share price appreciation).
However, not all companies pay a dividend. Generally, based on various financial and economic factors, the board of directors decides if a dividend is desirable for their respective company. Dividends are commonly paid in cash distributions to the shareholders monthly, quarterly, or yearly.
Dividend yields can vary significantly between companies, and they can also fluctuate from year to year. So investors unsure about which dividend-paying stocks to choose should stick to those that fit the dividend aristocrat label, meaning the company has at least a 25-year track record of paying out sizeable dividends.
Recommended video: Getting started with dividend investing
How to pick the best dividend stocks?
Consider these factors when on the lookout for worthy dividend-paying stocks:
- Long-term profitability is a crucial consideration. Seek out companies with long-term profitability and earnings growth expectations between 5% and 15%;
- Strive to find companies with healthy and sustainable cash flow generation, which is needed to pay those dividends;
- A minimal five-year track record of solid dividend payouts, which signals continued dividend growth;
- Avoid dividend-paying companies that are burdened with excessive debt. Examine a company’s debt-to-equity ratio and avoid companies with debt-to-equity ratios higher than 2.00;
- On top of analyzing a specific company’s fundamentals, educate yourself about broader sector trends.
Pros and cons of dividend investing
- Potential for double profits: share price appreciation and dividends;
- regular payments;
- Companies tend to increase their dividend payout rate annually;
- Generally, low volatility as dividend-paying stocks tends to be large-cap companies with stable earnings and growth.
- Limited future growth potential;
- Lack of diversification;
- Dividends are not guaranteed; companies can choose to suspend dividend payouts during challenging times.
Historically, the average dividend yield (the percentage of the current share price you get annually in dividends) on S&P 500 index companies that pay a dividend fluctuates between 2% and 5%, depending on market conditions.
Note: To learn more about this investment strategy – read our in-depth guide on dividend investing.
#2 Cryptocurrency staking
Cryptocurrency staking can present digital asset holders with a way of putting their digital assets to work without selling or trading them. As of April 2022, according to Staking Rewards, the total value of cryptocurrencies staked has exceeded the $280 billion threshold.
Staking crypto is similar to putting money in a high-yield savings account. When you deposit money in a savings account, the bank takes those funds and typically lends them to others. In exchange, you receive a portion of the interest earned from lending.
Likewise, when you stake your digital assets, you lock up the coins to participate in operating the blockchain network and maintaining its security. In return, you can earn rewards calculated in percentage yields, typically much higher than interest rates offered by banks.
Watch the video: What is proof-of-stake? Earn passive income with staking (on Ethereum)
How it works
Staking is only possible via the proof-of-stake (PoS) consensus mechanism – a method blockchains use to select honest participants and verify new blocks of data being added to the network.
Network participants (validators or stakers) purchase and lock away a certain amount of tokens, incentivizing good behavior within the network. If the blockchain were to be corrupted through malicious activity, the native token associated with it would likely plummet in price, and the perpetrator(s) would stand to lose money. Staking, therefore, is an effective way of preventing fraud and errors in this process.
The most prominent cryptocurrencies you can stake include Ethereum (ETH), Cardano (ADA), Solana (SOL), Luna (LUNA), Avalanche (AVAX), Polkadot (DOT). In addition, most of the more well-known crypto exchanges, such as Coinbase, Binance, and Kraken, offer staking opportunities on their platform.
Pros and cons of staking coins
- Lower entry requirements compared to mining;
- More energy-efficient than mining;
- More flexible between staking different coins compared to mining;
- Typically, higher returns than mining coins.
- Cryptocurrencies are highly volatile;
- Some coins require a minimum lock-up period making you unable to withdraw your assets;
- If you do decide to withdraw your assets from a staking pool, each blockchain has a specific waiting period before getting your coins back;
- Staking pools can be hacked, in which case you would lose the entirety of your staked funds. Furthermore, because the assets are not protected by insurance, there’s little hope of compensation;
- Highly technical, driving most non-technical investors to opt for staking services;
- Opportunity costs are particularly high;
- An added counterparty risk of the staking pool operator. If the validator doesn’t do its job correctly and gets penalized, you, too, might miss out on rewards.
According to data collected by Staking Rewards, the average staking reward rate of the top 261 staked assets exceeds 11% annual yield. However, rewards can change over time.
Remember, fees also affect rewards as staking pools deduct fees from the rewards for their work, affecting the overall percentage yields. Therefore, you can maximize rewards by selecting a staking pool with low commission fees and a good track record of validating many blocks.
Note: To learn more about this investment strategy – read our in-depth guide on cryptocurrency staking.
#3 P2P investing
Peer-to-peer (P2P) lending, also known as “social lending” or “crowdlending,” enables individuals to obtain loans directly from other individuals, removing the financial institution as the middleman. Currently, most P2P lending platforms operate in the UK and the US, with the trend slowly approaching Europe and some Asian countries.
P2P lending directly connects people with stagnant funds interested in lending to individuals in need of credit, enabling the lenders to earn higher returns from their investments and borrowers to access quick loans more conveniently (online) and transparently.
Lenders have the money they borrow reimbursed monthly in EMIs (equated monthly investments), including principal and earned interest income. The P2P lending platform collects the EMIs on behalf of the lender from the borrower and adds them to the lender’s escrow account from where the lender can withdraw or reinvest.
Another critical point is that lenders’ risk is diversified, meaning tens or hundreds of creditors with different risk profiles, demographics, and occupations invest in one loan. And as a result, reducing the loss in the event of the borrower’s insolvency since it’s shared between multiple investors. In addition, P2P lending platforms involve innovative products and processes to cut down on the time and effort needed to create a portfolio.
Recommended video: Peer-to-Peer lending explained in 1 minute
How it works
P2P lending earnings have the potential to become passive income through savvy investment choices.
An investor can withdraw EMIs or reinvest them back in loans listed on the platform. Firstly, data shows that lenders who reinvest earn up to 10% more returns than those who don’t. Secondly, by activating reinvestment, lenders ensure that their monthly earnings automatically get reinvested in the same products or plans they have selected and continue to generate returns.
P2P lending platforms provide automated investment options that reduce the time and effort required to build a portfolio, creating a straightforward process for you to add funds to auto-invest and select the various parameters which match your investment strategy with borrower profiles listed on the platform.
Systematic Income Generation Plans
The latest, most efficient, and least time-consuming method of investing in P2P lending is when many investors pool their funds into a single portfolio to achieve efficiency in portfolio building and management. The platform’s algorithm will disburse the pool money into a diverse mix of loans and loan products (with the repaying capacity) to provide high returns.
Pros and cons for investors
- P2P lending platforms are especially appealing to those who want high financial returns with minimal work;
- Low entry requirements: you can start investing with as little as 5 EUR;
- Demands less knowledge and experience than other popular investment methods (stocks or bonds). Many platforms have an automatic investment option.
- No insurance/government protection, no concrete regulations: The government does not provide insurance to the lenders in case of the borrower’s default;
- You may have to pay additional fees on top of the interest rate charged for the loan;
- It is not available to everyone: some jurisdictions do not allow P2P lending.
The amount of money you can earn differs from one platform to the next and from one jurisdiction to another. Therefore, ultimately, it is possible to make considerable amounts using P2P lending platforms, generally between 5% and 10% annually.
Read: To learn more about this investment strategy – read our in-depth guide on P2P lending.
#4 Index fund investing
An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio designed to track the components of a financial market index, such as the S&P 500. Rather than choosing individual stocks for investment, you can own a slice of various companies by investing in index funds. Furthermore, index funds are affordable, enable greater diversification, are generally low risk, and generate attractive returns over time.
Index funds are commonly regarded as ideal core portfolio holdings for retirement accounts, like individual retirement (IRAs) or 401(k) accounts.
The Standard & Poor’s 500 index is one of the most famous indexes because the 500 companies it tracks include large, well-established U.S.-based businesses representing a vast range of industries. However, some other options include Nasdaq Composite, Dow Jones Industrial Average, and Wilshire 5000.
Index funds whose portfolio of stocks are designed to track S&P 500 include Vanguard 500 Index Fund Admiral Shares (VFIAX), Schwab S&P 500 Index Fund (SWPPX), Fidelity 500 Index Fund (FXAIX), Fidelity Zero Large Cap Index (FNILX), Rowe Price Equity Index 500 Fund (PREIX).
Watch the video: What are index funds?
How to choose an index fund
When buying an index fund, it’s essential to consider several different aspects. Foremost, consider how much risk you are willing to take for the return and the potential risks associated with the fund you’re interested in. Then, set up a strategy that fits your investment goals and compare transaction costs of funds that cover the same sector.
Here are some factors to keep in mind:
- Company size and capitalization;
- Location: some funds focus on stocks that trade on foreign exchanges or a combination of international exchanges;
- Business sector or industry;
- Asset type;
- Market opportunities: funds that examine emerging markets or other nascent but growing sectors for investment.
Pros and cons of investing in index funds
- Reliable performance/stability;
- Low costs;
- Easy diversification.
- Lack of flexibility;
- Tracking error;
- Gradual returns;
- Management differences.
The S&P 500 index serves as a benchmark of the overall performance of the U.S. stock market. It has returned a historic annualized average return of around 10.5% since its 1957 inception through 2021.
#5 Real Estate Investment Trusts (REITs)
REITs are companies that own, operate or finance income-producing real estate, such as apartments, storage facilities, warehouses, offices, malls, and hotels. They are a popular investment method among numerous investors who seek to expand their portfolios beyond publicly-traded company stocks or mutual funds.
REITs allow individual investors to collect dividends from real estate investments without buying, managing, or financing any properties themselves. In addition, most REITs are publicly traded on major securities exchanges like stocks, making them highly liquid instruments (unlike physical real estate investments).
REITs can be classified based on how their shares are bought and held:
- Publicly Traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors;
- Public Non-Traded REITs also registered with the SEC but don’t trade on national securities exchanges;
- Private REITs aren’t registered with the SEC and don’t trade on national securities exchanges.
According to Nareit, an estimated 145 million U.S. investors own REITs either directly or through their retirement savings and other investment funds.
Watch the video: How do REITs work?
Start by opening a brokerage account, where you’ll be able to buy and sell REITs just as you would any other stock.
If you don’t want to trade individual REIT stocks, it can make a lot of sense to buy an ETF or mutual fund that vets and invests in a vast selection of REITs. You get immediate diversification and lower risk, and investing in them is less time-consuming than researching individual REITs for investment.
Some of the top-performing publicly listed REITs so far this year include Bluerock Residential Growth REIT, Inc (BRG), Preferred Apartment Communities, Inc. (APTS), and Gladstone Land Corp. (LAND).
And some of the best-performing property-focused mutual funds so far this year include Heitman US Real Estate Secs Inv (HTMNX), T. Rowe Price Real Estate (TRRX), and T. Rowe Price Real Estate Advisor (PAREX).
Pros and cons of investing in REITs
- High liquidity (publicly traded REITs);
- Low volatility;
- Steady cash flow through dividends since REITs are required to pay 90% of their yearly income as shareholder dividends, offering some of the beefiest dividend yields on the market;
- Higher returns compared to equity indexes;
- Attractive risk-adjusted returns.
- Low growth;
- Low liquidity (especially non-traded and private REITs);
- Dividends are taxed as regular income;
- Subject to market risk;
- Potential for high management and transaction fees;
- Non-traded REITs can be expensive; the cost for an initial investment in a non-traded REIT can go for $25,000 or more;
- Heavy debt, REITs are usually among the most indebted companies.
Note: To learn more about this investment strategy, check our comprehensive REIT investing guide.
Real estate investment trusts are one of the top-performing asset categories out there. The FTSE NAREIT Equity REIT Index is what a majority of investors use to measure the performance of the U.S. real estate market.
Between 2010 and 2020, the index’s average annual return was 9.5%. And more recently, the three-year average for REITs between November 2017 and November 2020 was 11. 25%, comfortably above the S&P 500 and the Russell 2000, which racked up at 9.07% and 6.45%, respectively.
Many people worldwide earn income by making savvy investment choices and implementing a system that helps them exploit their skills with minimal labor. Passive income is one of these ways and refers to earnings derived from various sources without putting in a considerable amount of time, energy, effort, or other resources.
However, it is crucial to understand that passive income often requires research and relevant knowledge before you start to earn money and a sometimes hefty up-front investment.
For most people, creating this new revenue stream will involve investing money made from more conventional means like employment or investing our time building a source of income from the ground up.
What is passive income?
Passive income is a cash stream that demands little or no daily effort to maintain and isn’t directly linked to how many hours you’ve worked. Passive income generally calls for an up-front investment that continually generates income flows without requiring the investor to monitor or actively adjust their holdings.
What returns can I expect?
Returns vary between passive income approaches and strategies, and the risk you’re willing to take. But, on average, you can expect returns anywhere from 5% to 11%, which is still a lot more profitable than low-yield savings accounts.
What are common mistakes to avoid when passive investing?
You should never invest money you cannot afford to risk; always consider your risk tolerance and potential returns, and don’t let emotions get the better of you. In addition, try not to buy into stocks you don’t understand, and be sure to diversify your portfolio. Finally, perhaps the biggest mistake is not investing at all, as inflation rates will often erode your hard-earned cash sitting on low-yield savings accounts.
How to learn passive investing?
There are endless avenues to learn passive investing online. You can find both paid and free courses, but try to avoid ‘get rich fast’ scams. Another great source is Youtube and verified financial websites that provide various guides and ideas completely free.