When it comes to money there is a simple ratio which tells us the real story of how wealthy we are. Here it is:
Financial Wealth = Passive Income / Earned Income.
We should be aiming for a number which is greater than 1: The reason this is such an important formula is that it takes into account the most important and scare resource – time. While it includes money, it goes beyond it. It infers that earning money from control and ownership of assets is far superior to earning money through labour – regardless of how big the earned portion of our income may be. Passive income does not require our time to be earned.
So what things are included in Passive Income? They include but are not limited to Shares (Dividends), Property (Rents), Licensing Rights (Royalties)… the assets we’ve acquired or built which put money into our pockets. What it is not, is the net value of those assets, just what they generate in real returns – actual cashflow. Much like a salary is a ‘real’ return on our labour. And while trading large capital assets may generate actual cash returns, that return is singular and only available at the point of transaction. Unless we happen to be in the business of trading assets, it doesn’t provide a true month to month reflection on our cash position. Passive income is about earnings and probability of those earnings to be maintained over time.
Why Passive is more important than Earned: Speaking of probability, another reason passive income is so vital is that it has a high probability of increasing. Rents and corporate earnings in most developed economies increase at around 10% per annum. Wages on the other hand increase annually at less than 3% per annum. Passive income also removes the power of others. When we earn wages, we are at the whim of the work environment, the company, our boss, the economy, technological upheaval, and all other manner of things which make having a job inferior. Earned income is riskier than than passive income because it generally is not something we control. Sure we can influence it by becoming more skilled and valuable to the marketplace, but we can never have total decision authority like we can with allocating our money to a portfolio. Word of warning – passive income, doesn’t mean it shouldn’t be actively managed, or that we don’t need to earn money to acquire it – it takes effort, but builds independence. In other words a passive attitude doesn’t build passive income, quite the opposite.
As mentioned in an earlier post about building financial wealth passive income is the money we earn when we are not in the room. This is actually more important than total income is. Firstly, passive income usually grows over time. Rents go up, anyone who has rented a house knows this pattern. In good companies earnings increase over time. Secondly, passive income is important, because it should be regarded as bonus money. We can manage to live on the earned portion of our income. We know this is true because most people start with zero passive income – unless you’re a trust fund baby. The passive portion becomes it’s own eco system of building more of itself – think compound interest. More on this later.
A story about the Stars: Not those in the sky, but rock stars, sport stars and movie stars. There is no shortage of stories about these people going broke. Bankrupt after earning zillions of dollars. In fact this statistics is very telling: By the time they are retired for 2 years, 78% of NFL players are bankrupt or under severe financial stress. This documentary – ESPN 30 for 30 Broke is worth watching on the topic. How is this even possible? The reason rock stars and sports stars go broke is because they have a poor ratio. Pure and simple. They earn big, have bad spending habits and don’t create a good financial wealth ratio while they have the chance. It should be easier for them than anyone, and most don’t take their opportunity. They don’t de-risk their future.
A story about the Rich: Look at any rich (financially rich) people you know, famous, or even that local business person you admire and you’ll see a good ratio. They own properties, have equity stakes in successful businesses and make the majority of their money from the passive side, not the earned. Even most employees who get rich – think CEO’s – become so from share options more than they do from pure wages. The pattern is clear.
How to hack your ratio: The trick is to move money from the earned income denominator to the passive income nominator. Until at some point there is more passive than earned income resulting in a ratio of 1 or greater. So long as we keep our spending in check, once we earn more money passively than actively, work becomes a choice for both type and frequency. Another hack for building this equation in your favour is ensuring your earned income and passive income are in the same realm or industry. This usually gives you an advantage in your passive income building as your skill base moves you up the learning curve of both sides of the wealth equation. This strategy often results in bigger returns both earned and passive as they interact interdependently. Stick what you know, and leverage knowledge advantage to beat the averages.
Know your ratio: We should know your position, your ratio. You should have a plan to increase the passive portion. The problem is that most people go through life aiming to increase the earned portion more than they do the passive portion. This ends up as a micro version of the rock star problem. The life style spending increases with the income. Knowing your ratio allows you to aim and game the system. To set targets for increasing the passive side. If your ratio is 5% this year, then aim to acquire investments to make it 10% next year.
Other advantages with the Wealth Equation: In most economies the taxation system gives large advantages to passive income. Often dividends are fully franked (the tax is already paid for you). You can offset your earned income with the expenses associated with generating your passive income. You don’t have to pay tax as you earn this money (PAYE), and can earn interest on the returns before it gets taxed. As well as many other structural benefits, such as paying lower corporate tax rates (30% company vs 45% top rate for a mere human) via holding the passive income assets in a private company.
How to build Passive Income: Save at least 10% of what you earn and invest it. The two simplest places to invest would be residential property and index shares. Invest the return on investment from the passive income into more passive income generating assets – never spend any of it. If we can manage to do this, then as soon as our ratio is 1. Work becomes a choice not a necessity.
To do: Add improve your wealth ratio to your goals list for 2015.
New book – The Great Fragmentation – out now!