According to Wikipedia, Dutch artist Vincent Van Gogh is the most-represented artist on its list of the most expensive paintings ever sold. There is a real element of tragedy here, because during his lifetime it is believed that the Dutch master only sold one of his paintings. This was a very low strike-rate, given he produced more than 2,000 paintings. Van Gogh died virtually penniless in 1890, 100 years before his Portrait of Dr Gachet changed hands for a cool $US82.5 million. (It is now estimated to be worth at least twice that amount).
All this goes to show that being good at what you do does not guarantee you a high income. That is one of the real limitations of active income (the income that you receive from your labour). You can be absolutely brilliant at what you do, but if the community does not value that work, you will not be paid very much – even if the thing you do is very important (hello teachers, nurses, social workers and artists as good as Van Gogh).
The other limitation of active income is that it is usually tied to the amount of work that we do. Wages are tied to time explicitly, as we are paid an hourly rate and thus our total payment is the hourly rate times the number of hours we can work. The number of hours we can work is finite, limited as it is by, if nothing else, the number of hours in the day. Accordingly wage income is also finite.
Salaries, which do not tie themselves to hours worked quite as precisely, are nevertheless still mostly limited by the amount of time available. Even though salaries are not overtly calculated by multiplying an hourly rate by the number of hours to be worked, try telling your boss that you think you can get all your work done in three days a week, rather than five, and see what he or she says next time they are reviewing your salary.
So, the income from the work we do is limited by (i) the time we have available to do it and (ii) the extent to which the community wants to pay us to do that work. This makes active income inherently limited in terms of wealth creation and financial freedom.
As financial advisers, notwithstanding its limits, we understand that active income remains an important part of the wealth equation. We regularly help people to find ways to generate more active income, for example, by talking through various career options that would allow people to be paid more for the same amount of hours worked. That said, we also understand that one of the best things we can do for our clients is guide them to develop ways to generate passive income.
Passive income is the income generated by investments. Because it is not linked to our time or (necessarily) our skill, passive income is not limited in the way that active income is. Indeed, it is possible to earn passive income even while we sleep.
There are really three main types of passive income: interest we receive when we lend someone our money (including payments for holding bonds and the like), rent we receive when we let people use our physical assets such as property, and dividends we receive when we use our money to buy ownership stakes in income-generating businesses. Capital gains that come when we sell assets is sometimes also seen as another form of passive income.
Passive income comes from investments, so it requires us to already have some wealth to invest. Usually, this wealth is referred to as capital. Unless we inherit money, sell an asset we have created or luck in and find a way to generate high levels of active income relatively early in life, capital can take a while to accumulate. The good news is that we can get started investing with relatively little in accumulated capital – and we can usually add to our investment as we save more in the future. We can also add to our capital by re-investing the passive income that we generate from our investments, allowing the income we generate to ‘compound.’ Compounding means what we earn ‘income on income we have previously earned.’ It can also be quite magical.
For example, if we invest $10,000 and earn 6% with all earnings reinvested at that rate, then the investment will grow to be worth $20,000 after 12 years. After 24 years, however, it will be worth $40,000. After 36 years, it will be worth $80,000. That is the magic of compounding – the same rate of return generates more passive income as the amount of capital invested increases.
So, if you have not yet started to generate passive income, or you would like to generate some more, give us a call and let’s discuss how you, too, can generate income while you sleep.