In my earlier article, I have explained that our retirement or financial security should be based on the passive income we have and not on our net asset. The reason is simple. If you rely on a huge pile of money to live on, you may finish it one day. Even if you don’t, you might do something foolish in your old age and cause the money to be gone. In contrast, if you have a regular flow of money, you can never run out of money. Even if you do some foolish things and lost all your money, you can always wait for the inflow of income next month. Therefore, passive income is the only way to achieve financial freedom.
In this article, I am going to give you a brief run down on the various sources of passive income. Please note that this article is not exhaustive in itself. It is only a brief introduction. You have to do in-depth study on the topic you are interested in. In addition, this is article is only an expression of my personal opinion. I am an engineer, not a financial expert. The difference between engineers and financial experts is, financial experts are trained to obey everything written in their textbooks while engineers are trained to think and analyze.
Let us begin.
I have used this as examples in my earlier article because it is the most obvious form of passive income. You buy a property and rent it out. Every month you receive rents. Everyone can understand this. Not only that, you don’t have to fork out money to pay for the whole property. Banks and financial companies are willing to provide loans with favorable interest to help you to buy your property. (This is my only appreciation for banks. I like to take their money and not give them money.)
So, you only need to come out with a fraction of the property price and borrow the rest. As long as the rents you receive are more than the total of loan installments and other expenses, you have a net positive cash-flow. Your tenants pay for your mortgage installments and give you some income. Don’t you think this sound like a business from heaven?
There are basically 3 benefits from this option:
1. Positive cash flow which can serve as passive income.
2. Amortization because your equity in the property increase each time you pay off the mortgage installment from the rents you receive.
3. Capital appreciation of the property.
The main obstacle is in finding the right property, buying it and renting it out. The hard work is in the beginning. After that, you only have to wait for money to flow in.
How to start? You have to do your homework and read up on the subject. I am attempting to start my real estate empire but I currently cautious of the property prices in Singapore. Property prices here have been rising despite the absence of any clear economic recovery. I don’t like to get in now. My strategy is to wait for another downturn in property prices before I make my move. I am also looking at properties in Malaysia. All I need now is a reliable agent in Malaysia. Any recommendations?
This is also simple to understand. Buy shares on companies that have a good track record in giving out consistent dividends. Companies that can afford regular dividends must be very stable and have secured profit base. They should be quite safe. However, the problem is the shares of such companies will also be in high demand. Their share prices must be very high. So, the dividend yield, (derived by dividing the dividend per share with share price) will be very low, thus making such shares unattractive.
The only time, you can get them at attractive yield is during a bear market. At the time where the whole world is rushing to sell, we can find good bargains like companies that pay regular dividends. The main problem here is companies only pay dividends once a year. Dividends are more like bonuses than salary.
Is there any way to get monthly income from shares? The answer is yes. That is the next category.
Selling covered call options.
This only applies to optionable shares. I am not going to provide a comprehensive explanation on options here. I suggest you find out yourself if you are interested.
Here is the trick. Sell one call option on every share you own at a higher strike price. You will receive the money from your sales immediately. Your broker will lock up the shares that you sold options on. The shares are still legally yours but you are not allowed to sell them as long as the options you sold are still around. Those shares will only be released on either one of these conditions:
1. The sold options expired worthless.
2. You buy back the options you sold.
What will happen then? First, as explained you will receive a certain amount of money for selling the options. This money is yours to keep. Then it depends whether the underlying share prices exceed the strike price of the options you sold.
If the share prices remain below the strike price within one month until the expiry of the options, the options will expire worthless. The broker will release the shares back to you and you can repeat the process of selling options on the following month. The point to note here is that if the company pays dividend, you can still receive it even if the options you sold are not expired yet.
The question here is how much can you get by selling covered call options. Based on my study in US Stocks, it is possible to sell one month call options at more than 3% of the underlying share price. If the shares are worth $10, you can sell options at $0.30 for every share you own. If you repeat the process every month without compounding, you will receive a total of $3.60 a year from the $10 share you own. This works out to the annual yield of 36%. You would have beaten most of the fund managers.
However, the above scenario only works if the share prices stay below the strike price at the expiry of the options. What happens if the underlying share prices shoot above the strike price at the expiry of the option? Your broker will force sell your shares at the strike price.
Here is a numerical example.
1. You have shares worth $10.
2. You sell the call options at strike price of $11 for $0.30.
3. You get to keep the $0.30.
4. Your shares price move above $11 at option expiry.
5. Your broker will take away your shares and pay you $11 per share.
In short, you still get to keep the money from the sales of options and additional profit from the force-sell of your shares. However, you will not be able to repeat the process of selling covered call options because you no longer own the shares to cover.
What is next? You have a lot of cash in your broker account but no more shares. Do you intend to buy shares to sell options on or sell cash covered puts? You need a Plan B on what to do when share prices go above the option strike price. Only then, will you have a complete option selling plan.
This method is not completely passive. You still have to do some work but the work is only once a month. After you sold your options, you only have to wait for them to expire in one month. Then, you work again either on Plan A or Plan B. All you need is a computer, internet connection, broker account and some capital. You can do this anywhere in the world as long as there is internet connection.
Please note that this is not options trading. Trading involves buying and selling. This method is only about selling only.
The advancement of internet allows the trading on almost everything by everyone. Trading basically involves identifying entry points, make the entry with direction and exit with either profit or loss. There are many books and seminars out there teaching people how to trade. The trading method you can get from the are all mechanical systems. All you have to do is to follow the rules and odds are supposed to be in your favor.
This is not exactly passive unless you can get the computer to trade for you based on specific rules. Such facilities already exist. In fact this is something I am doing right now. I have a forex trading account that allows me to choose the automated trading system I want and I specify the risk parameters. The software will do the rest.
Let me tell you why this is the best business ever. Most businesses require commitment. You can either commit a lot of money or a lot of time. If you have a lot of money, you can put in a lot of money. If you do not have a lot of money, you will need to commit a lot of time and hard work.
Automated trading is the exception here. It requires relatively lesser money to start with and it does not require a lot of time to manage it. The money I invested into this account cannot be used to start a restaurant. I do not wake up in the middle of the night to trade. The computer program does it for me.
So, I suggest you consider this option seriously.
This is the type of business that requires you to commit a lot of time. Network marketing sounds good in theory. Here is how it works. You recruit 10 people. Each of the 10 people recruits 10 other people. The process keeps repeating until the entire city becomes your network.
The problem is it does not always work as planned. I got into it once but never make any money out of it. What I don’t like about it is I am not suppose to use the word “network marketing” when I introduce myself as though it is something I am ashamed of. I don’t like that. If I am in this business, I want to be able to state unashamedly that I am into it but doing so will scare my prospects away.
Another problem with this option is the products they sell are expensive despite the claims that they have eliminated many middleman. So, their marketing strategy is to sell the business rather than the products.
I don’t mind doing it if the products are cheap and common like toothpaste. I can then tell my neighbours, “Instead of going to the supermarket to buy toothpaste, why don’t you buy from me? The price is the same and you can save on the transport cost.” Unfortunately, I cannot find any network marketing groups that sell cheap and common stuffs yet.
Should you get into it? It depends. If you happen to be a very outgoing person and have a lot of friends, you may want to give it a try. Just remember not to spend too much money in it.
This option is those who has a lot of money sitting around. Think of McDonalds. How much talent do you need to open one? The answer is none. All you have to do is to pay them what they want and they will provide everything you need to start one. Your work as the boss is only to follow instructions from the franchiser and you get to call yourself an entrepreneur.
Since the job is about following instructions, you can even hire a manager to do it for you. Your role then is to collect money.
Personally, I find this to be a good balance to properties. When the rental yield is high, buy properties and rent them out. However, if the rental yield is low you can rent some space and do some franchise in it. You get to benefit no matter where the rental rates move.
This is all for now. Let me remind you again that this article is not exhaustive in itself. You have to to your own research.