December 14, 2020
Imagine a life where you don’t have to work anymore, but you still keep making money. It sounds too good to be true, right?
However, plenty of people are still able to retire early and live life on their own terms without financial stress – because they learnt how to generate passive income. It’s a simple concept – you invest your money in other “money-making” devices which generate more income for you.
The more efficiently you manage your money, higher the returns you get and over time they accumulate, giving you a large enough chunk so you can retire and live a stress-free life.
How does passive income work?
One of the first rules of being financially independent is to “let your money work for you.” There’s a lot of wisdom behind these words. You regularly invest an amount which reflects growth over time. This growth varies for different investment products – mutual funds, stocks, deposits, bonds, income generating real estate.
To be more precise, passive income is a highly desirable situation for the long term as long as you get the basics of investing right – inflation, allocation and asset classes. Inflation in the form of travel, medical, entertainment etc. is much higher than the general index and needs to be factored in one’s estimates for growth requirements.
Just like how your active job takes a major chunk of your time, the passive income too, needs a full-time manager. That is why it is always good to hire someone who understands the ecosystem better and can guide you and your money in the right direction. While there may be a small fee to pay for it now, it is worth it in the long run.
Asset Allocation & Product Selection
Asset allocation is done with a mix of evaluating the risk profile and overall timelines of your goals. Its importance cannot be overstated. Over 90% of the returns of a portfolio are achieved on the basis of asset allocation. It simply means defining a fixed portion of portfolio for investment in fixed income and equity as per risk profile and goals. This proportion has to be maintained over a long-term, and if there is a deviation due to market movement, then it must be re-balanced to bring the proportion back to the defined level.
As for Product Selection, picking the right set of Mutual Funds, Stocks and Bonds requires a good understanding of products. For example – there are more than 8,000 schemes available in the market. If we look at the category average of the Mutual Funds, they have not beaten the index because eventually, it becomes the average of all the schemes present in a particular category, and not every scheme will beat the index. Thus, picking the right ones is important.
Risk is applicable to all the products available in the market, there is no guarantee of Fixed Income products not defaulting or delaying payments, we have seen this in case of ILFS in Bonds and PMC Bank in Deposits. If the risk reward ratio isn’t optimal, then it is a warning sign. ILFS gave an 11% return in an 8% market and instead of viewing it as an opportunity one
would have done well to question why an investment would give such high returns unless the fundamentals aren’t great. Identifying good products which are suitable for your profile requires research and understanding of the ecosystem.
Note – It is important not to confuse your assets with liabilities. Investing in a real estate property means you’re still paying for the maintenance, so it becomes a semi-passive investment. Considering the fact that it takes time to sell a property too, your real estate investment becomes a liability then. That is why you have to be extra careful when you purchase a property, so do your research thoroughly.
How to identify these passive income vehicles?
It is important to invest, and invest well. One of the first steps you need to take before identifying passive income vehicles is budgeting your active income. THis is ideally what you earn from your business or from a day job as salary is used to meet your regular as well as lifestyle expenses. Your active income needs to be converted to passive. If you’re starting now, here are a few ways to build your passive income –
- Equity (Share market)
- Fixed income (FDs and Bonds)
Equity-based investments can fulfil long-term goals and beat inflation. There are equity mutual funds which are an excellent option for equity investments because they are managed by professionals who understand the market better and make decisions based on numbers and logic. Their functioning is fairly transparent, however, there is volatility involved in equity investments. On the other hand, there is no volatility in FDs, but the returns are low. Hence, an efficient risk profile will allow you to stabilise your investments.
A question may arise – why not simply pick mutual fund managers to get the job done?
That is because Mutual Fund managers know the product best while a wealth manager knows and understands your requirement and can accordingly bring the right balance between equity, FD or bond to your portfolio.
The next step in identifying investment vehicles is to understand the return on every investment. At the very least it has to beat the inflation. Generally, moneyback insurance policies provide a return of 4-6% which is lower than the inflation. FDs give 6 to 8% returns which after TDS and high taxation rates reduces the compounding effect of your returns.
Compounding is an important concept of wealth creation.
For example-
If you invested 1.5L every year from 1996 in PPF till 2017 then total investment is 33L and the maturity value is 86.44L (8.12% Return) whereas if the same investment was made in Mutual Fund Equity Linked Savings Scheme (ELSS), the same 33L investment would have become 5.67 Cr (21.60%). During this 21 year period there were times when ELSS investment would have seen volatility but over time this also resulted in generating higher growth in the portfolio.
Making the right plans –
To make a plan, you need to list your financial requirements and list of expenses so as to understand the quantum of investible funds and then bifurcate them into various investment options based on your requirements. Like the saying goes “Don’t put all your eggs in one basket”, as explained above make a combination of Fixed Income and Equity for your plan.
A good example of smart passive income investing is retirement planning. If you reach a stage where your passive income is more than your active income, you can retire and live a comfortable life. For example, if your active income is Rs. 1CR, then to have passive income of the same amount the assets you own must generate an income of Rs. 1CR and at a 10% return you need an investment of Rs. 10 CR. Once the target is set, you can plan and invest accordingly to reach the desired level.
So, start working on your finances and start investing in a planned and disciplined manner to financially retire whenever you want and work only for passion.
