Generating multiple passive income streams sounds like the best and most secure way to reach financial independence. But this is not necessarily the case. In this article, I would like to tell you about the biggest mistake that people who want to generate multiple passive income streams make and the misconception they have about it. Besides, I’ll show you what you should be focusing on instead.
What’s wrong with multiple passive income streams? Nothing but…
It sounds so nice to have multiple passive income streams. You have written an eBook here. You run a blog, publish videos on YouTube every week, and have many affiliate links.
Of course, you also have a full-time job. Besides, you don’t only invest in stocks, but also in ETFs (what’s the difference?). You bought an apartment to rent. You give P2P loans, and now you’ve even started with puts and calls options. The money comes from all sides, and some small springs become a flood on which you sail peacefully towards financial freedom.
Mh meh, maybe, but first, you should think about one or two things. Please don’t misunderstand me.
I think it’s excellent when people try to generate cash flow and move their asses to pursue their happiness.
So for the record: Passive income is great. Honestly, I feel connected to anyone who tries to generate one or another income stream. I also pursue this goal.
But I have some difficulties to follow the guidelines that you find on the internet. I don’t even think they are wrong, and I also see the altruistic intention. But when I read advice like “Build up xy income streams!”, there are some misconceptions that you should know.
More is not always better
The biggest problem is that the number of passive income sources does not say anything about their quality or the allocation of risk.
If you can do a lot of things a little bit, then you’re not good at anything
The first obvious problem is that if you can do many things a little bit, you’re not good at anything. Behind this banal insight lies the fact that we humans are not made to master certain things perfectly. We can’t run fast, we can’t see well, we freeze quickly, and we depend on others’ communities.
In short: Humans can do everything a little bit, but actually, humans are beings full of limitations. From an evolutionary perspective, this has definite advantages because it has enabled humans to adapt much better to nature and the environment.
However, when it comes to standing out, our nature is disadvantageous because we need to act against our nature to become great in something. And I believe the necessity to act against own nature is a core problem for many people. The hunter-gatherer in ous says that the more income sources we build up, the better and safer it is for ous.
But this consideration is wrong because the risk is high that we will always remain average instead of concentrating on one thing and becoming good at it. As a result, you lose a strong lever with which you could increase your passive income much faster and more effectively (I will explain what I mean in a moment).
More income streams do not automatically mean less risk
Moreover, it does not mean that your total wealth or total assets’ risk decreases with each new passive income source. A perfect example is an employee (active income) who invests part of his salary in shares of his company (passive income).
He may think that he has particularly useful insight into the company. Besides, he believes that he knows precisely what excellent management is working there. And buying shares of the competition would be out of the question for reasons of conscience alone.
But the problem in terms of risk allocation is this: If there is a crisis and the company goes bankrupt, the employee loses his active and passive income. Hence, he has gained nothing at all. It would have been much more rational if he had bought shares in his employer’s fiercest competitor.
Another example is the allocation of income streams to several asset classes. Just take a look at the chart below. There you can see from individual examples that it is possible to achieve high returns as well as low returns with the same asset class.
You can also see similar risk profiles for each asset class (low risk, medium risk, high risk). So it doesn’t make much difference if you invest in two different assets with the same risk profile. So before you rashly shoot at anything that promises a return, you should, therefore, gear your investments more closely to your risk profile.
It only makes kind of sense to look at the risk correlation
The only theoretically sensible reason to buy different asset classes with a similar risk profile is if the risks do not correlate. A low correlation exists when one asset class performs poorly, and the performance of the other asset class remains positive. To test if and to what extent different asset classes correlate, I looked at the performance of the following asset classes since 1995:
- Crude Oil Price;
- US large caps;
- US small caps;
- International Stocks;
- Emerging Markets Stocks;
- High Yield Bonds
In the chart below, you can see that there was quite a high correlation between the most asset classes. Only two asset classes proved to be less correlative, and these were cash and high-grade bonds. However, these asset classes have not generated above-average returns (8+ percent) when other asset classes have crashed. They have merely mitigated the losses of the different asset classes. However, the same applies to returns in good times. Interestingly, gold is not the winner in times of crisis either. For example, in the year of the great recession in 2008, the gold price rose by just 3 percent.
So you see that the benefit you derive from distributing your passive income across as many asset classes as possible is limited. Investing in many asset classes only subjectively gives you a feeling of safety. Overall and objectively, however, the risk for you and your total assets remains more or less the same.
In the end, it’s simple
In the end, to generate a robust passive income is much simpler than the theory of many passive income streams. At the very beginning, there must be the concept of converting active income into passive income.
The better you are, the higher your market value
In our market-driven world, this has an interesting side effect. If you can do something better than the others and stand out above the average, your market value increases in the areas where you are skilled. And a high market value, in most cases, also means more income.
So it would be best if you try to get good at something to increase your market value. And you surely also know that it takes a very long time until you are excellent at something because otherwise, it would be easy for everyone.
This is another disadvantage if you try to build up as many passive income streams as possible. It will take forever or even become impossible for you to master a thing so well that a market value arises for you here. By doing so, you miss the leverage effect, which, in my opinion, is one of the most crucial aspects of generating passive income (see below)!
Furthermore, a specific market value alone gives you more freedom than some passive income. With high market value, you are already relatively independent. If you don’t like your job, you can just quit it. You will find a new job and be welcomed with open arms. You do not have to be mistreated by anyone, neither by your colleagues nor by your boss.
I think anyone who has achieved something like this is already fortunate. With this freedom, some people may no longer want to invest energy and effort in the project “multiple passive income streams”.
But now we come to the critical aspect of the lever!
The leverage: The higher the active income, the more you can convert it into a passive income
Passive income does not grow on a tree. You have to build up this passive income first. To do so, you will have to work actively. A book that you want to sell, you have to write beforehand. Your blog wants to be fed for years to come. In the same way, you have to actively earn money for stocks and ETF’s with a job.
The whole thing has the following consequence: the higher your active investment, the better and less risky you can leverage your passive income. That is why, in the long run, the rich will become more prosperous. Ten percent return of one billion is simply more than a 10 percent return per thousand in absolute terms.
An example: Suppose you want to generate €5000 per month. With a return of invested capital of 5 percent, you would need €100k active investment per month, for a total of €1.2 million per year.
If you achieve this 5 percent through dividends, you would need stock assets of over one million. Of course, I know that you can also save a lower amount through the compound interest effect. However, that again is at the expense of time.
That said, if you want to have €5,000 per month with dividends next year, then this year, you will have to invest a total of over €1 million in companies that have a dividend yield of 5 percent.
You can probably already see that there are some difficulties. Where do you get so much money? Besides, a company that provides a 5 percent dividend yield does not seem to be the safest dividend payer.
So what’s happening here is quite typical. You want to leverage the low initial capital with high returns. But the problem with this is evident because return always correlates with risk.
It would be smarter to leverage the absolute return with a high initial capital. And this is where the leverage of active income comes into play. The only thing you have to do is to have sufficiently increased your market value to use this leverage effectively.
And where do you think you can earn the most in the beginning? By trying to build up one passive income stream after another or by simply pushing your active income to the highest possible level? If you live a thrifty life, you can already invest money and start to convert your active income into passive income.
If you want to build a passive income, you should follow these guidelines
Increase your market value
In the beginning, you should focus solely on achieving the highest possible market value. Invest in your human capital, which means invest in your skills. It doesn’t matter if you study for it or not; the main thing is to increase your market value.
Focus on leverage
When you reach levels with a high active income, you should start to leverage your income and convert it into passive income. But again, focus on the best possible use of your lever. There is no point in investing hours in stocks analysis if you could simply buy ETFs that offer the same or often better performance over the long term.
Why should you try to buy several properties if you have no idea about the legal and tax aspects? Wouldn’t it be wiser to buy shares of several REITs simply?
Focus on risk diversification and risk allocation
The same applies to risk allocation. Here too, less is more. What is the point of many asset classes if the risks are related? You invest precious time and work here, which you could spend better and more relaxed.
No matter how you use your leverage, make sure you have a proper risk assessment. You mustn’t let possible yields tempt yourself, but think long-term and sustainable. Blue-chip stocks might be an excellent opportunity for this. But you can also invest in an ETF that includes thousands of companies. Don’t be greedy; be patient.
Focus on life!
One essential thing, which I did not mention above since it should be obvious: Focus on life and enjoy it! Do not make yourself a prisoner of your self-optimization. Do not focus too much on the goal, but enjoy the journey!
Passive income is great, and I can only encourage you to build a passive income stream. But you don’t need many streams to do this; it is sufficient if you try to increase your active income as much as you can. Try to use a high income as leverage to generate more passive income.
My tool of choice? Stocks! Invest broadly! Buy simply stubbornly and steadily ETF. Then, enjoy how the compound interest effect makes your active income more and more superfluous with time.
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