Passive Income Investing in 3 Easy Steps

Just quietly, I think passive income investing is as easy as falling off a log. Just about anyone can achieve it.

Today, I’m sharing with you how we approached passive income investing. We approached our passive income investing in 3 distinct steps – I’m sure that with some thought, you could translate this method across to your own circumstances too.

Our 3 Step Passive Income Investing Method

Passive income is most easily derived from income investing and is achieved following these three steps:

1. Create a cash-flow portfolio first. Invest in quality high-income producing assets until all basic life expenses are covered by this income.
2. Next, create an income-growth portfolio. Invest in quality assets that increase their income year on year.
3. Finally, build a business asset from scratch. Be entrepreneurial and build an income producing asset from scratch. Base this on your unique knowledge and skills – you know, the ones that you could talk about all day! With your other two portfolios already built, there will be time to build an asset properly so it grows into a generational asset.

Our growth style investing friends may scoff at this three-step strategy and ply us with the mathematics about compounding and tax implications.

Nevertheless these same people will fall mysteriously silent in times of market drops, market volatility and sustained sideways markets (AKA the lost years) especially if they are relying on selling off portions of their portfolios for income. 

We on the other hand will have coins quietly rolling into our pockets every month whatever the weather.  As savvy passive income investors, actual cash-flow trumps paper profits every time – just ask any successful business owner.

Passive Income Investing is a Lost Art

Passive income investing has gone out of style in recent decades – growth style investing has been certainly ruling the roost.

Ask any modern growth investor and you will get a long list of compelling reasons as to why their way is the best (including a dizzying array of spreadsheets and theoretical graphs measuring paper profits to prove the point)

However, when we peel back all the noise, what we all need is income – coins in our pocket every single day that we can live off confidently.

Passive income investing done well, should produce steady, reliable & passive income streams irrespective of market and political gyrations. Passive income investing means you will sleep well at night, have all your bills and living expenses covered and also get an automatic pay rise every year. It will give you the freedom to live the life you want to live – a purposeful life.

Step 1 – Build a Cash Flow Portfolio

Contrary to popular advice, maximizing steady, reliable & passive income streams first is the key. 

This is done by regularly acquiring assets that are specifically designed to produce the highest regular output of income coupled with the steadiest movement of the underlying capital.

Additionally, these assets should have a fair and affordable cost structure.

Here are some examples of the types of assets you may include (in no particular order):

• Corporate bond closed end funds (paying monthly distributions between 7% – 12%)
• Real Investment Estate Trusts (paying monthly or quarterly distributions above 7%)
• Covered Call Index Funds (paying monthly distributions between 8% – 10%)
• Quality High Dividend Funds (paying quarterly dividends above 6%)

Often, these products are designed specifically with income/cash-flow investors in mind.

Doing due diligence on these products prior to investing is an absolute necessity to ensure the fee structure, underlying assets, historic performance and product structure is sound and the issuer and management is reputable.

I suggest a fund with at least 10 years of trackable history and very steady income distributions. I also suggest that you have at least 5 funds in this initial portfolio (and no more than 10)

The singular aim of this initial portfolio is to build up an income stream to replace your base income requirements as quickly as possible.

Once our base expenses are covered by the income produced by this cash-flow portfolio, we are essentially free from the stress of feeding and clothing ourselves and paying for shelter. 

We could stop there and just enjoy a quiet life, however this would be short sighted indeed. 

The next step is to adjust the type of income producing assets we purchase and create a separate portfolio of income growth assets.

Step 2 – Build an Income Growth Portfolio

Passive income investing for the longer term means thinking ahead. 

Unlike the initial cash flow portfolio that covers our base expenses, this next portfolio is focused on growing that income passively over time. 

This income growth portfolio will insure our income increases over time and keeps up with and/or exceeds average inflationary increases.

Assets that produce growing streams of income usually do not initially produce as much income as the assets in our first cash flow portfolio.

Instead, these income growth assets lift their income outputs to the investor year on year.

Whilst there is some overlap with the types of assets held in our cash-flow portfolio, usually the assets held in this income growth portfolio are based on steady growth industries where steadily increasing profits from consumer and industrial products support the year-on-year growth of distributed passive income to their investors.

Here are some examples of the types of assets you may include (in no particular order):

• Dividend Growth Funds (both traded and untraded)
• Individually picked companies that show a long history of dividend growth
• Closed ended funds dedicated to steady income growth
• (REITs) real estate investment trusts, companies and funds
• Well established infrastructure companies and funds

Often, these products are designed specifically with income growth investors in mind. Often they will state this as part of their objectives e.g. “To provide the investor with a growing stream of income over time”.

Doing your due diligence on these products prior to investing is an absolute necessity to ensure the fee structure, underlying assets, historic performance and product structure is sound and the issuer and management is reputable.

Over time, this second portfolio of income growth holdings will eventually overtake the cash flow portfolio in both capital value and income produced – but it is a longer game.

 Whilst we could start with this second portfolio as our first portfolio, it would take many extra years to realise freedom via passive income. Most investors would tire of the process.

Step 3 – Build a Business Asset

For those of us that are more entrepreneurial, we might want to consider building income producing business assets ourselves from scratch. 

Obviously, this income would be aspirational whilst we are building the asset up, however, building a business asset from nothing through to being a truly passive income source is a very satisfying undertaking and often will produce more superior income flows than investing in a ready-made product.

Being realistic is important. Building a business asset that will sustainably provide passive income for the long term takes patience, persistence, passion, resilience and lots of up-front labor. Unless you build a business asset based on something that you are utterly passionate and skillful at – you’ll burn out and de-energise. A business needs to energise you not kill you.

Here are some examples of the types of assets you may include (in no particular order):

• A business that is managed by a manager/board on your behalf
• A portfolio of income-producing websites managed by writers and technical staff
• Shares in a business where we are a silent/angel investor
• Royalties on successful literary products
• Repeat sales on self-created courses/plans/patents
• Rental income from an investment property portfolio managed by an agent

The reason I say to build this final portfolio last is, that you can spend a lifetime building a business asset that may come to nothing. By building the first two portfolios explained in this article first, you have your income sorted for life first – you’ll never be without income. That allows you to build and pursue the building of a business asset free of personal income worries.

So there you have it, that’s passive income investing in three easy steps.

Now, take action! Without taking action, it’s all a pie in the sky.

Cheers

Hugh Walker