Over the years, we have talked a lot about passive income. For the uninitiated, passive income refers to the money you earn from sources like 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 the course and get rich is to measure your success by the amount of passive income you are generating in cold, hard cash each year. Following this philosophy is simple because you can see tangible proof of your progress as checks are sent to you in the mail or directly deposited into your bank account.
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 you can imagine that throws off funds. They 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.
The major advantage of focusing on annual passive income as a metric for success is that it can help protect you from overpaying. This is a function of basic math. As prices rise, cash yields fall. An investor focusing on increasing his passive income isn’t going to find these low-yield investments nearly as attractive, providing a countervailing force as optimism sweeps the stock market or real estate market. He or she has inadvertently protected his or her family’s investments.
One of the biggest risks for men and women 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 3x, 4x, or greater 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%, 8%, 10%, 12% or greater, you are probably walking into one of these so-called traps. It might be a company that had a special one-time dividend from the sale of an asset, such as a subsidiary, 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. In any event, be careful. Passive income investing can serve you well but don’t get greedy and overreach for yield. As Benjamin Graham reminded us, more money has been lost by investors reaching for an extra half point of passive income than has been stolen at the barrel of a gun. He was right.
Andro Ferraro 