The 3 Buckets of Passive Income and Wealth Building
I spent the first decade of my career creating habits that helped me save and invest money.
I realized that reaching financial independence fast meant buying assets. Assets that produced growing cash flow and income. Assets like stocks choose to keep that cash flow or pay it to investors as dividends. Stocks are great because over time their earnings tend to grow. Which dividends will grow, which means more money for you the investor!
A portfolio of income-producing assets that grow faster than inflation is magical. It’s magical because it makes work optional.
To be clear, I’m not a fan of reaching for yield nor do I believe in high yield investing as a means to an end. If you focus on the 11 assets listed in these buckets. You’ll create a diversified portfolio that will grow and pay you to drink coffee and read books.
Each bucket has its own characteristics of income and growth potential.
Here’s how I break it down.
- Traditional Paper Assets
- Real Estate
- Small Businesses
Bucket 1 – Traditional Paper Assets
- Money Market (Savings, CD)
Bucket 1 is where all my energy flowed since I was a teenager and began investing in the stock market. In my opinion, it’s the only true way to earn passive income. Each month dividends roll into my brokerage account. Stocks dividends, bond dividends, and REIT dividends. The end of each month is like 12 mini Christmases.
No more work required. There’s something sweet about receiving dividend payments from my index funds. No commuting into the office. No late-night presentation prep. No all-day board meetings. No stressful deadlines to hit, and no boss nagging you to grow the business faster.
When you’re an owner of equity index funds, all those fancy overpaid CEOs work for you.
A quick note for tax purposes. The income generated by these assets will fall into the following categories:
- Interest Income
- Dividend Income
- Qualified Dividend Income
For the real personal finance nerds, check out Topic No. 400 Types of Income by the IRS for the details.
Asset #1 – Money Market // Savings Account // Certificate of Deposit (CDs)
I group these 3 similar investment options together because the net value to me is very similar. The rates and rules for withdrawal will vary by product and by the bank. Parking cash in these investment vehicles is safe and there is little risk to your principal. At interest rates near historic lows, expect little income from these investments.
Money market and savings accounts both produce minimal yield and are highly liquid. It’s common for these accounts to limit the number of withdrawals per month. Not a big deal if no that and can plan accordingly.
Certificate of Deposits is another way to invest your cash. I’ve never been a huge fan of CDs. They’ve always felt like an investment vehicle with an identity crisis. Not quite a money market account and not quite a bond fund. The low yield and illiquid nature of the investment continue to be uninteresting to me.
Asset #2 – Bonds
I’ve always invested in bond funds and ETFs. A total bond market ETF provides diversification across thousands of bonds and sectors.
There is volatility when investing in bond funds. The bond market responds to changes in interest rates and demand for risk-free assets. When bond price rises, yields fall, and vise versa. You can reasonably expect to earn a return equal to the yield of the bond if held over the duration of the fund.
There are 4 sectors of the US bond market.
- Government (Federal Treasury Bills)
- Municipal (State and Local Governments)
- Corporate (Debt issued by companies)
- Securitized (Mortgages and other pooled debt)
Investing in a total market bond fund or ETF will get you exposure to all but the municipal sector. The government sector of the fund includes only nominal treasury bills. If you’re interested in inflation-protected bonds, TIPS, you’ll need to buy a separate ETF.
Asset #3 – Stocks
Not all stocks pay a dividend but the S&P 500 does. Investing in an index fund that tracks the S&P 500 will pay you a small dividend each quarter. With today’s current valuation the yield on US stocks is small, less than 2%.
Investors that own international stock also can expect quarterly or yearly dividends. Broad index ETFs like VEA and VWO commonly pay dividends high than the US.
Dividend-paying stocks are a popular niche. When bond interest rates are low, they compete for capital.
Popular Vanguard ETFs used to capture a slice of these dividend-paying stocks are VIG and VYM. There is no free lunch in the stock market. Higher yield funds have lagged the S&P 500 over the past few decades. Your total return matters. So understand the trade-off when you pick ETFs that pay you more in dividends today.
Asset #4 – REITs
A simple and easy way to gain real estate exposure to your portfolio is to invest in a REIT index fund. Real estate investment trusts (REITs) focus on purchasing, developing, and improving real estate. REITs are required to pay 90% of their net income to shareholders as dividends. The yield of the REIT index tends to be higher than US stocks but there is just as much volatility in price.
The dividends for REITs get taxed as ordinary income or nonqualified dividends. Something to keep in mind when planning for taxes or asset location.
Homeowners may already have a considerable size of their net worth tied up in their homes. Additional real estate exposure through REITs may be risky.
Bucket #1 – Recap
Investing in the assets in bucket 1 has made many millionaires in this country. The assets in this bucket also provide the only truly passive income. Log into your brokerage account and count your money for years to come! Pour yourself a nice cup of coffee and count your dividend checks, Mrs. Rockefeller.
In my opinion, the assets in bucket 1 are the best choice to build wealth during your working career. They work just as hard as you do, while you focus on rapidly growing your income.
The downside of this bucket is the current yield. Low-interest rates and high valuations. Yields are low across the board for money markets, bonds, stocks, and REITs. It takes a considerable portfolio size to produce the income for a FIRE or fat FIRE lifestyle.
Don’t worry high achiever, there are more ways to produce income outside of work!
That brings us to bucket #2
Bucket 2 – Real Estate
Buying and owning income-producing real estate is a dream for many FIRE seekers. High achievers buy, own, and operate many real estate properties. The math is compelling, and when you own enough cash flowing properties, traditional 9 to 5 work becomes optional. This pursuit must be a labor of love. As any real estate professional will tell you, this is not passive work or income.
Asset #5 – Single-Family Properties
Buying a home and renting it out for monthly income can be a great option for many people. Up and coming cities, also called 18-hour cities, are compelling areas to invest. Ambitious entrepreneurs in the FIRE community focus on acquiring several rental homes. Each cash flowing home becomes a building block for their FIRE plan. Ever wonder how many rental properties you need to retire?
Asset #6 – Multi-Family Properties
Purchasing multi-family properties for income can be fun and lucrative. It may be easier to finance and manage multi-family properties depending on the town you’re investing in.
Many FIRE seekers buy multiple properties, live in one of the units, and rent out the rest. This is a way to live rent-free while you pay down your mortgage and collect rent from your tenants.
Asset #7 – Short Term (Vacation) Rentals
Airbnb took the world by storm over the past few years and open up a whole new way for people to travel the world. It also enabled thousands of people to earn extra income by renting their homes. It also sparked a new generation of entrepreneurs buying properties with the sole purpose of renting them out on Airbnb or VRBO.
Vacation towns, like the one I grew up in, are now filled with short term rentals. A week or two of rental income can be enough to cover your monthly expenses. After that, the rest is gravy!
Owning vacation rentals can be labor-intensive. Weekly turnover, cleaning, crazy guests on vacation who give zero effs. I view this asset as a labor of love. It can be a lot of fun for the super host that enjoys helping travelers and families have a great vacation experience.
Buyer beware, there is a growing legislation risk in many towns and cities. Real estate agents and hotel owners are losing customers and significant revenue due to Airbnb. Fees and possible bans of short term rentals are on the horizon in many vacation towns. Get to know your town and town counsel before parking your cash in a short term rental property.
Asset # 8 – Crowdfunded Real Estate (Private Equity)
Are you interested in investing in real estate? Are you looking for a lower effort and a more passive way to do that? Crowdfunded Real Estate may be interesting for you. There are many online platforms that offer investors access to private deals.
With the emergence of sites like Fundrise, investors can now get access to these non-public deals. Investors can access debt and equity positions in real estate deals across the country.
Bucket 3 – Small Business
There are over 30 million small businesses in America. These businesses employ about half of the American workforce.
Owning and running a small business can be challenging work. However, equity ownership in a small business is a powerful tool for wealth building. There are also thousands of very boring businesses that print money.
Do you have a passion for business and growing cash flow? Is the product or service less important to you? If yes, owning all or part of a small business might be right up your alley.
Asset # 9 – Digital Online Business
The internet is a wonderful place to make money. The ecosystem changes quickly but it’s hard not to notice the world’s obsession with the smartphone.
Building and buying websites is a very niche market. Content creators, digital marketing, or media buyers should consider this niche. These jobs hone the required skills to build and grow online communities.
An online business can be as simple as owning and operating a website. A blog is essentially an online business. I guess if you have a really successful blog it magically turns into a website or media property.
Asset #10 – Franchises
Entrepreneurs that don’t want to start from zero would enjoy buying a franchise business. McDonald’s is a great example of a franchised business. After an owner acquires a license from McDonald’s. They get access to the branding, operating knowledge, supply chain, services, and products. In return, the owner pays upfront fees and yearly fees or profit shares back to the parent company.
You basically buy a business model that’s proven to work. As a franchisee, you just need to execute and grow your business in your local market. There are thousands of franchises in America. There are online directories like Franchise Opportunities, that list businesses for sale. Who knows, you might be the next Warren Buffet of UPS Stores.
Asset #11 – Service Businesses
This is a very interesting and often misunderstood asset in my humble opinion. I wish I learned more about service businesses when I was in high school. Interesting examples include plumbing, electrical repair, landscaping, pool cleaning, house painting, pest control, waste management, and moving services.
These boring and repeatable services help make the American dream go round. There are mini plumbing empires all across the country run by men and women with high school degrees. They make amazing incomes and take care of the shit that you don’t want to deal with. Literally, they take care of your shit. It’s awesome stuff, and it’s a shame we’ll never get to know these people.
This is a tough niche to get into and may require a good chunk of capital. However, small businesses are a secret weapon for making a lot of money for a long time.
Collect Assets That Produce Cash Flow
Buying income-producing assets takes time. Start today with traditional paper assets. It’s the easiest and lowest cost way to become an owner. As you become more experienced explore real estate and small business. These assets can provide more income than the low yielding world of stocks and bonds. This can diversify your portfolio and help accelerate your path to freedom.
The best time to plant a tree is 20 years ago. The second best time is today. Be patient my young high achiever, one day your assets will reach a critical mass. When it does you’ll be financially independent.