Living on income, financial independence, financial freedom… you can say it in many ways, but in the end, it all refers to the same goal: To have the freedom to decide what to do with our time without money being a constraint.
Having a job or owning a business is something I always recommend, I couldn’t live without working, but why live in fear of losing our job or business and therefore our main source of income? If we earn passive income, we can live with extra peace of mind.
In this article I will outline the pros and cons of some investment strategies with which you could also, one day, earn an income.
Stages for earning an income
Before looking at the different ways to earn an income, we need to know the two phases necessary to achieve it:
- Capital accumulation phase: This is the period when you are earning income and saving money. Normally, in this phase, you can assume more risk/volatility by having income from an external source. All the money you accumulate (whether in the form of equity, investment, real estate or other) will be the money that will provide you with capital tomorrow.
- Income earning phase: This is the phase in which you can earn income. The income that you obtain comes from the income from what you have accumulated in the previous phase. This is a time where you have to be much more cautious as the lifestyle is supported by investments.
What to invest in?
Here are the 4 ways to invest that I am considering:
1 – Dividend investing
Dividend investing involves buying shares in companies that have historically paid dividends. Some people focus on companies in their own country that they know well and pay dividends, while others prefer to diversify by adding companies from other countries.
They tend to follow Buy & Hold or Dividend Growth investment strategies, i.e., investing for the long term, trying to maintain the investment in the same companies as long as they continue to pay dividends (if possible, increasing dividends).
Although it is important that the value of the share rises, the most important thing is the percentage of dividends paid out of the total invested, known as a dividend yield.
It is usual to invest in a greater or lesser number of companies (e.g. 20) to diversify the risk, but without exceeding the amount, otherwise, its review and control become more complicated.
It is a popular strategy as its followers gradually see how money enters their accounts and how this income grows over time if they continue to invest and choose the right companies.
- Dividends are usually paid out on a scheduled basis, so you have a forecast of when you will receive them.
- You usually have a good knowledge of the companies you invest in because you choose them yourself.
- As you only need the dividends, the number of shares remains the same regardless of their value (although after the dividend is paid out, the value of the share usually goes down).
- You have more control over the assets that make up your portfolio (at the level of individual companies).
- Option to use this strategy through dividend-paying mutual funds, a simpler but much less customisable variant.
- Very low geographic diversification if you only invest in your home country.
- Impossibility of tax deferral of dividend gains during the accumulation phase.
- Much more time spent on selecting and monitoring the companies in the portfolio. Ideally, the portfolio should be built up gradually by taking advantage of market opportunities.
- Need to have a 100% equity portfolio unless complemented by fixed income or bond funds.
- Requires knowledge of the main financial ratios of companies as well as knowledge of the different business sectors.
2 – Investing in index funds
Investing in index funds consists of investing in investment funds that replicate a stock market index (e.g. S&P 500, Eurostoxx 50). Not needing to pay a manager or team of analysts dedicated full time to analyse the companies allows for very low fees. This is why it is also called a passive management strategy.
Multiple studies indicate that this type of investment has offered better long-term returns than the more traditional investment in mutual funds (active management). In my opinion, it is the most sensible way to invest money.
It is also a very popular way to invest for income as the knowledge is not so high and the time needed to manage the portfolio is very low.
- Possibility to diversify globally with very low fees and in a simple way.
- Tax deferral of dividends distributed in accumulation investment funds (you are only taxed when you redeem them).
- Easy adaptation of the portfolio to the risk profile and personal circumstances by varying the percentage of equities vs. fixed income.
- Possibility of using roboadvisors if you do not have a high level of investment knowledge and/or do not want to spend time periodically creating and managing the portfolio.
- Need to sell fund units in the income-generating phase, even if the accumulated capital volume is maintained.
- Need to remain flexible depending on market movements, as the portfolio is replicating it. This is sometimes difficult to bear on a psychological level when there are downturns (it is a long-term investment so you have to be strong!).
- Uncertainty about the portfolio’s future performance as you have less control over the assets in which the fund invests.
3 – Investing in real estate to obtain rents
Real estate investment consists of buying a property and renting it out to earn rent on a month-to-month basis. In addition, under normal conditions, the price of the property increases in value over time.
Personally, I consider real estate investment to be an interesting investment as long as it is to obtain rent from a tenant, not to make use of it (I would not consider it an investment) nor with the pure intention of speculation (I think it would be unprofitable in the long term).
- Some stability in the rental income stream.
- Low correlation with stock market fluctuations.
- Ownership of a tangible asset that you could one day use yourself.
- Possibility of low-interest leverage (credit).
- Low liquidity investment.
- Little diversification (unless you have many properties in different cities/countries).
- Need, in many cases, for leverage to carry out the investment (mortgage).
- The complexity of reinvesting the capital obtained in the same type of asset as the minimum investment is very high.
- Possibility of having to face unexpected payments that reduce profitability.
- Difficulty in calculating the real profitability of the property due to the multiple expenses required both for its purchase and its maintenance.
4 – Investing in crowdlending platforms
Crowdlending investment consists of many people lending small amounts of money in exchange for interest. In this way, a high degree of diversification is achieved by being able to invest a small amount of capital in a large number of loans.
Its investment is becoming increasingly popular in Europe as it offers very attractive returns, investment automation and, in some cases, repurchase guarantees that add a layer of security to operations without completely eliminating risk.
- High returns (+10% per annum is achievable in principle).
- Theoretical decorrelation with the stock market.
- Wide range of platforms.
- Simple, digital sign-up processes.
- A little history in Europe.
- Difficult to measure the risk of the loans you invest in.
- Low liquidity if the platform does not have a secondary market.
- There are a lot of platforms and it is difficult to choose the best ones.
Note: I want to make it clear that I would find it extremely risky to want to live on income only with crowdlending loans.
Other ways to earn money
As I said at the beginning, there are other ways to invest or earn money in order to achieve financial freedom.
Some of them might fit as a way to generate more income in the accumulation phase, but you should be aware of the following:
- Trading: Investment in a very short-term stock market. Although many people are fond of trading and can earn from it, I consider the possibility of losing money to be too high, as well as requiring a large amount of time to devote to it.
- Startup investing: Investing in companies that are in very early stages (startups). It is a type of investment that can be very profitable but the risk is too high and the liquidity too low; it could be used during the accumulation phase (if you know a lot about it) but I would not recommend it at the time of earning income.
- Investing in cryptocurrencies: I think it is an asset to consider for de-correlating the portfolio and/or as a store of value (as gold could be), but I do not consider it a suitable strategy for long-term income.
- Investing in art: Buying works of art such as paintings or sculptures to sell them over time for a higher price. I think this is an extremely complicated and highly illiquid way of investing. Moreover, the fashion of the moment can influence the price of the work and there is a risk that it will deteriorate over time.
- Playing the lottery: The probability is so remote that I don’t even consider the possibility of playing. I consider that rather than an investment it would be a donation or a hidden tax, especially when you pay to play and, in some countries, you also pay when you win.
- Gambling, casino, slot machines…: Worse than playing the lottery. I consider it a hobby that can be very expensive, as well as dangerous for people with addictive tendencies. Some people have ruined their whole family because of gambling addiction, so you have to be very careful with this kind of “strategy”.
My strategy for generating passive income
I have a predilection for investing in index funds.
I believe that for the accumulation phase, investing in index funds is the most interesting option as it is highly diversified, liquid, requires little time and tax-deferred until the capital is withdrawn. I am ruling out dividend investing because of the taxation of the payments and because I do not want to spend so much time analysing and managing my investment portfolio.
On the other hand, I believe that investing in real estate can be a good investment strategy for the income phase combined with another investment strategy, so I may consider investing in a house at a later stage. (If so, I will keep you informed).
I have also started to invest a small part of my assets (<10%) through equity lending platforms, as they offer interesting returns and a low correlation with the stock markets.
Finally, I would like to stress that there is no need to stick to a single strategy to generate, a mixture of the ones I have explained is perfectly valid to achieve financial independence as long as you know their particularities well and you put them into practice wisely.