What type of income is truly passive?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

──────────────────

The term "passive income" has become more widely used over the years, with many individuals aiming to F.I.R.E (Financial Independence, Retire Early) by living off their passive income.

However, what can truly be considered as passive income? Most individuals would generally consider dividends, interest and rental (and for some, even credit/debit card cash rebates) as passive income. Majority would agree that these are passive income. But technically speaking, passive income can only be derived from assets with little to no risk — hence the term "passive", where one doesn't need to take on any risk to earn the income, allowing one to adopt a truly "passive" approach towards his/her investments.

A prime example of passive income would be interest earned from investing in risk-free assets like T-bills, CPF, SSBs or bank deposits (within the $100k SDIC limit). Such investments or deposits typically do not entail any risk and therefore can truly be considered as passive income. Investing in equities or real estate may not provide truly passive income as it involves risks inherent to the global economy and market fluctuations and also risk inherent to any specific company, industry or country.

In most investments, individuals typically take on both systematic and idiosyncratic risk. Unlike risk-free investments like T-bills or CPF, such investments are not completely risk-free even though they can provide a steady and increasing flow of passive income. An asset which is able to consistently generate a reliable, high and growing passive income may not necessarily be risk-free.

For example, the rent earned from an investment property is compensation for undertaking the risks involved in purchasing and owning the property such as capital risk, mortgage risk, etc. The maintenance and upkeep cost of the property entails some risk which the owner has to stomach in exchange for rental income (and/or capital appreciation). Such costs may escalate quickly especially as the property ages, which would eat into the owner's rental income. 

Similarly, equities entail risk. While they may consistently pay out growing dividends, this does not mitigate the risk that inevitably comes from investing in equities. As such, the only truly passive income is the risk-free return, exemplified by risk-free assets like T-bills, SSBs, bank deposits or AAA-rated government bonds.

Therefore, while most individuals may categorise real estate or dividend paying stocks as relatively low risk investments, and thus view the rental or dividend income collected from them as passive, this is not entirely true. Only income generated from risk-free assets like T-bills or bank deposits can be considered as truly passive. So while the term "passive income" may be used loosely to encompass dividends and rental income, it is important for investors to not view such investments as low risk or as completely risk-free sources of "passive" income, especially when planning for retirement. 

A truly passive income would entail little to zero risk. Viewing such non risk-free income sources as completely passive could affect one's retirement planning. If things go south, the outcome could be detrimental, especially with inadequate retirement planning or inaccurate estimates based on the perception that dividends and rental income are 100% passive income sources which entail little or even no risk.

So while categorising dividends and rental under passive income is generally fine (and widely accepted), it's important to be aware on the subtle differences between "passive" income from non risk-free assets and truly passive income generated from risk-free assets when making important financial decisions like retirement planning where many rely on passive income.

While it's ideal for one's basic retirement expenses to be at least covered by truly passive income from risk-free assets, it's oftentimes difficult for many to achieve as the risk-free rate alone is usually insufficient to generate enough passive income from our savings to cover our basic expenses during retirement. Unless we have a large pot of savings, depending solely on the risk-free rate to generate passive income for our retirement needs is usually insufficient for many individuals. As such, many strive to earn a higher percentage of return above the risk-free rate on their savings.

Aiming for our portfolio to earn above the risk-free rate inevitably entails taking on risk. And we are compensated for this risk with a return above the risk-free rate. For example, dividends and rental income typically yield between 4%-6% per year (or even higher if there's capital appreciation) while the risk-free rate may be around 3%. The difference between the risk-free rate and what we earn from our investments in these non risk-free assets is compensation for taking on the risk of investing in such assets. 

An important principle to keep in mind is that it's impossible to earn anything above the risk-free rate without taking on some risk. If an investment promises us returns above the risk-free rate with zero risk, it's most likely a scam or there are some undisclosed risks.

Therefore, if it's our goal to generate a return above the risk-free rate, we must be prepared to stomach at least some risk, which entails forgoing some truly passive income (from risk-free assets) for other types of income such as dividends or rental income. For many, this is usually the most viable option to ensure they can F.I.R.E at their desired age. Taking on higher risk in their income-generating portfolio will enable them to earn above the risk-free rate to generate sufficient income to fund their expenditure for retirement. Depending solely on the risk-free rate to generate income is not usually the most suitable choice unless you have an exceptionally large pot of savings or exceptionally low retirement expenses.

By taking on risk in one's investments, while the income earned will no longer be considered truly "passive", it is still able to bring home the bacon to meet our retirement needs with a steady, consistent and reliable flow of income, regardless of whether it is truly passive.

Conclusion

While it's good to allocate a certain percentage of our portfolio to assets earning above the risk-free rate, it's important not to confuse between truly passive income and income earned for taking on risk. It's also crucial to keep in mind that such income generated from non risk-free assets isn't truly passive, because it's simply a reward for taking on risk. As with any decision, taking on risk exposes us to the possibility of undesirable outcomes such as capital loss or not receiving any income from such assets.

But as long as we are prudent in how we manage and allocate our savings, and ensure we continue to spend well within our means, we would be well-positioned for a comfortable and stable retirement regardless of the economic climate or performance of our portfolio. 

Having a sufficiently large buffer will ensure even if our portfolio is severely underperforming (i.e., experiencing a worst case scenario), we still have sufficient income and savings to tide through such times which are usually temporal, as long as our portfolio is well-managed, and most importantly, well-diversified across different asset classes and industries.

──────────────────

Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

No copyright infringement intended. The images used in this blog are solely for educational and informative purposes, and are © copyrighted by their respective owners.

Copyright © 2024. All rights reserved. SN Finance Blog