Blog | Personal Finance

What is Investing for Passive Income? (And Why is it Important!)

It’s during hard economic times that you can really tell the difference between two vastly different types of investors.

play cashflow now

It’s during hard economic times that you can really tell the difference between two vastly different types of investors.

I’ll explain by sharing an example of two recent exchanges I had with some good friends.

One friend, a successful doctor, met me for lunch.

“How’s things going?” I asked.

“It’s rough out there,” he said. “My 401k is taking a beating.”

This wasn’t surprising. The stock markets have been hammered recently. I could see how his perception of the market would be a negative one.

I was at a conference with another friend, a successful investor in real estate. I asked the same thing I asked my doctor friend, but his response was very different.

“I’m doing great! Cash keeps coming in, and I’m on the hunt for discounted properties to build my portfolio.”

What was the difference between these two investors? I’d like to start answering that question by first exploring three different types of cash flow patterns.

The three different types of cash flow patterns

I’ve written about the three different types of cash flow patterns before, but it will be helpful to review them here as well.

The cash flow pattern of the poor

The poor are often known to lament that they live paycheck to paycheck. And they’re not wrong. Most poor people have a cash flow pattern that looks like the one below. Income comes in the form of a paycheck and promptly goes out to various expenses.

If they’re lucky, they can cover their expenses each month. If not, they take on debt, often in the form of credit card debt, which only makes them poorer and increases their monthly expenses. The only way they can get ahead is to get a higher paying job or another job…just to make ends meet. It’s a very sad way to live.

CF pattern- Poor

The cash flow pattern of the middle class

The poor aren’t the only ones who live paycheck to paycheck. Below is the cash flow pattern of the middle class.

CF pattern- Middle class

The middle class can often seem rich to the outsider looking in. They might have big salaries, fancy houses, nice cars, and more. But what they really are is just living the Rat Race. Instead of putting their money straight to expenses to live, like the poor, they buy liabilities like vacations, houses, and luxury cars, which then means their money goes from there out the expense column. They might also put some money in a 410k, like my doctor friend, but as I’ll show later, that also is a liability, not an asset.

The interesting pattern for the middle class is that as they get more liabilities, their taste grows and they want more. So they get a higher paying job and then buy more liabilities. But here’s the scary part, if they lose their job, they can’t cover their expenses. Why? They don’t have any income outside of their salary, and they often have large liabilities and expenses. If they’re lucky they can get a new job before it catches up to them. If not, they declare bankruptcy.

The cash flow pattern of the rich

The rich have a vastly different cash flow pattern than the poor and the middle class. It looks like this:

CF pattern- rich

Very simply, the truly rich obtain their income from their investments in the form of cash flow. They then use this income to buy liabilities and pay their expenses. They don’t rely on a job or a salary to do this. The money comes in each month in the form of passive income.

The difference between earned and passive income

The biggest difference between my doctor friend and my real estate investor friend is that of earned vs. passive income, which is really at the core a mindset difference.

Let’s start by looking at the CASHFLOW Quadrant.

To be financially free, you must move to the right side of the CASHFLOW Quadrant.

E is for employee

Employees value security and look for a great job and salary.

S is for self-employed

The self-employed value freedom and independence, but they don’t play well with others. They are the best at what they do, so they don’t trust others. They don’t own a business, but they own a job. If they don’t work, they don’t earn. So while they have freedom in the sense that they are their own boss, they aren’t really free because they still have to work.

B is for business owner

Business owners value independence and freedom as well, but they obtain it by building a system and a team. They don’t have to work to earn, because their business makes the money.

I is for investor

Investors are the smartest financially of those in the CASHFLOW Quadrant. They use their money to make money by investing in assets that produce cash flow each month.

The difference between those on the left and right side of the quadrant is that of mindset and cash flow. Es and Ss are concerned with security, so they work for earned income, that is income others generate and then pay them for their efforts. Essentially they sell time.

Bs and Is are concerned with true freedom. They build businesses and make investments that provide passive income to cover their expenses. If they don’t want to, they never have to work another day in their life.

Two types of investing: capital gains vs. passive income

Those on the left side of the CASHFLOW Quadrant can sometimes think of themselves as investors. For instance, my doctor friend did when he talked about how poorly his 401k was performing. But the reality is he is not an investor, but rather a gambler.

Es and Ss often have high intelligence, just not financially. I can’t do what my doctor friend can do. You don’t want me making your health diagnosis. But I know a lot more about money than he does. Because he has low financial intelligence, even though he makes a lot of money, he is concerned about his money.

Because he puts his money into a 401k, he is at the mercy of it going up and down each month. Even worse, it’s actually a liability because it takes money out of his pocket each month and doesn’t put any money in. It could be an asset, but only if he collected the earnings. Until then, it’s a liability, and hopefully when he’s ready to retire it will be up. It’s not today. Here’s what his investing pattern looks like:

capital gains diagram

He’s investing for what is known as capital gains. He’s hoping the price will go up and that he can sell to make money in the end. It’s a gamble but like all bets, it can pay off. Unfortunately, it also is the highest taxed investment.

My real estate friend is on the right side of the CASHFLOW Quadrant, where folks invest for passive income, a.k.a, cash flow. She earns rent from her properties each month, enjoys great tax benefits, and has only a small amount of her own money in her deals. Because she has long-term leases, her income is consistent, even in a down market. And when the market goes south, she sees only opportunity because the types of assets she buys, rental properties, go on sale. Because she invests for passive income, her assets cover her expenses each month. She enjoys true freedom. Here’s what her investing pattern looks like:

cash flow pattern of the rich

Types of passive income investing

Hopefully you’ve learned enough to know that investing for passive income is vastly superior to any other type of income. To finish out this post, I’d like to quickly share different approaches to investing for passive income to get your mind going. My advice is to see what interests you most and then do a deep dive to learn all that you can about it.

Real estate

I’ve already hit on this in the post, but real estate is my favorite investment category for passive income. In real estate, your passive income is made up of rents. Simply put, if your rent covers your expenses, you will have passive income. The more investments you have or the larger they are, the higher your passive income. Additionally, there are great tax benefits and the ability to use OPM (Other People’s Money) to easily get into real estate.

Stocks

I get knocked often for being against stocks. While I don’t like stocks as capital gains investments, I do like them for passive income. Two types of investments you can make in stocks for cash flow are dividends and the covered call strategy. If you want to learn more about these, I encourage you to read this in-depth post, “Investing for Cash Flow With Stocks.”

Business

You do not have to be a business owner to enjoy the benefits of the B quadrant. A great way to create passive income is to invest in other people’s businesses. As an investor, you can have control, often in the form of a board seat, and help steer the course of a business to great profitability. Unlike a business owner, you don’t have to manage the day to day or be responsible for the operating aspects of the business. You simply enjoy the profits in exchange for your capital.

Start investing for passive income today

While investing for passive income is a great strategy, it does take financial intelligence. I encourage you to start by learning everything you can about the investments you’re most interested in. Also, learn everything you can about money. Take classes, hire a coach, and consume as much free education as you can. There’s so much out there in terms of resources. More than ever in human history. All you have to do is take advantage of it, and then make your move.

Original publish date: July 11, 2022

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