The topic of passive income has been making the rounds lately.  More specifically,  the blogosphere has been debating the passivity of certain forms of income, such as blogging and real estate,  as opposed to dividends and interest payments.  To that end, I’ve devised a complex, sophisticated mathematical formula to divide all forms of income generation into 8 levels from lowest level of passivity to greatest. 

Level One: Contracting and Self-Employment
Passive Component: 0%

Working as a contractor is trading time for money in its purest sense.  While contracting obviously has many advantages like flexibility, variety of work, and higher pay, it is also the least-passive form of income.  A contractor only gets paid for hours actually worked.  If you take the day off, you don’t get paid.  The same is true for self-employed individuals such as lawyers, plumbers, etc.

Level Two:  Full-time Employment
Passive Component: 2.573%

Full-time employment is still trading time for money, just like contracting.  Unlike contracting, however, full-time employees usually get paid vacation, sick days, and often even disability and life insurance to protect your family’s income in the event of tragedy.  These characteristics add a small passive component to income from your job, but only a very small one.
business with employees

Level Three:  Owning and Running a Small Business With Employees
Passive Component: 31.7%

Owning a small business is a lot of work and I doubt most small-business owners would consider it to be anything approaching “passive.”  And yet, delegating responsibilities to employees allows you to leverage the time of others to expand and maintain your income without dedicating any of  your own time to those tasks.  Once successful, many small business owners can slowly but surely extract themselves from the day-to-day running of the business and earn a full-time income working part time.

Level Four:  Real Estate Investing, Landlording, and On-line/Blogging Income
Passive Component: 67.97%

Blogging income certainly isn’t passive at first glance.  It takes a lot of time and a sustained effort over several years to become successful, but it does have a strong passive component.  Once your masterpiece has been written, attracted a few quality links, and gotten high rankings in the search engines, that particular post will continue to draw traffic and generate revenue for years to come.  While regular time and effort are required to generate new content to draw traffic and generate more revenue, a certain percentage of your blog’s income will persist indefinitely so long as your posts are remain in the search engines.  That is passive income.

Real estate investing also has a strong passive component.  Once you’ve bought and renovated your property, most properties (absent annoying trouble tenants) require only a few hours per month of your time to collect rent and do routine maintenance.  Serious maintenance problems can be farmed out to contractors.

Level Five: Individual Stocks, Bonds, and Income Trusts
Passive Component: 85.0001%

Dividend and interest payments from carefully-selected stock or bond investments are excellent sources of passive income.  They take significant due diligence in the beginning, but once purchased require very little intervention.  Of course, you do have to regularly monitor your investments to be reasonably certain your future income streams are secure.

Level Six:  Actively Managed Mutual Funds
Passive Component: 91.33%

This category, which includes hiring a competent financial advisor, is even more passive than individual income investments because they tend to be far more diversified and require less due diligence to buy.   You still have to monitor your investment manager’s performance to fend off persistent underperformance, but that takes little time.

Level Seven:  Broadly Diversified Index Funds and ETFs
Passive Component: 98.8%

Index funds, unlike actively-managed mutual funds, will never underperform the market by a significant margin and require almost no on-going effort.  You must still make asset allocation decisions and rebalance periodically, however.

Level Eight:  Target Retirement Mutual Funds
Passive Component: 99.9999999%

Target retirement funds are the gold standard of passive income, if you’ve got a large enough portfolio to generate a livable income from one.  You make only one decision:  what year you want to retire.  Once you’ve decided that, you just purchase the target fund that corresponds to your time horizon.  If you don’t care about growing your income in real terms but merely generating enough income to pay the bills, you can choose a target retirement income fund, which hold most of their assets in bonds and other income-generating assets.

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