How To Build Defensible Passive Income Streams

I do not believe the key to long-term financial security is diligent saving and investing in index funds (although I recommend index funds), nor real estate (although REITs hold real potential), nor savvy stock picking through your favorite discount broker, nor starting the next Microsoft, nor even niche blogging (although that’s the route I’ve taken).  The key to long-term financial security is none of these and all of these at once.  It goes without saying that if you get extremely lucky with any of the above wealth-building strategies, you could become a multi-millionaire, but consider the following possibilities:

• The next Microsoft might get sued by the old Microsoft, forcing you out of business
• The commercial real estate market might crash again, taking your REIT dividends with it
• Google might stop sending lucrative search traffic to your blogs
• Your next stock pick might turn out to be a dud
• The market might be flat for the next 10 years

Any one of the above so-called passive income streams could stop producing at any moment.  If you rely on Google for 70% of your online revenue like I do (I know, I’m working on it), one shift in the rankings could wipe out a sizable portion of your income (it’s happened to me at least twice).  Any one or even combination of two of the above strategies is unstable at best.  But imagine if you had 7, 8, even 15 different passive income streams, none accounting for more than 15-20% of your total income?  Even if your business crashed and burned, you’d be able to pay the mortgage.  Even if your financial stocks cut their dividends in half, you’d be able to eat.  The value of building defensible passive income streams is obvious.  Here’s how to build them.

What Do We Mean By Defensible?

A defensible passive income stream is one that doesn’t require a lot of ongoing work to maintain but that isn’t overly reliant on any one outside entity (i.e. an entity you don’t control) in order to function.  A portfolio of 10 or so income-producing blogs on different topics you post to a few times a month in your spare time can be an excellent defensible passive income opportunity, especially if no single source of traffic (i.e. Google) accounts for the majority of your visitor.  One or two blogs on the same or similar topics that receive 70% of their traffic from Google are not defensible.  While the search-dominant blogs will probably be much more profitable on a per-visitor basis, the spigot could get turned off at any time without warning.  It’s happened to me, and it wasn’t fun.

Examples of Defensible Passive Income Streams

Note:  By “Passive Income Streams” I don’t mean income sources that don’t require any work to maintain, merely sources where the bulk of the effort comes at the beginning.  If I have to spend 40 hours to get a website up and running or make a real estate deal but only 2 or 3 hours per month maintaining it, I consider that a relatively passive income source. Pat Flynn’s Smart Passive Income blog is an excellent resource for learning how to generate income passively.

• Broadly-Diversified Total Market Index Funds - These funds tend to yield less income than their income-focused cousins, but their dividend payouts are generally much less susceptible to market shocks.  Remember that income funds focused on the Financial Sector would have seen their payouts decrease dramatically last year while total-market investors would have been fine from an income perspective (although they would have lost principal).  While hassle-free and extremely reliable, this is probably the least lucrative passive income stream around so it should probably be the last you tap into.
• Your Own Small Business – Getting into business for yourself is risky, tis true, but at least you are the primary determinant of your own success or failure.  If something isn’t being done how you want it to be done, you can change it.  Okay, so this probably isn’t the most “passive” of income sources, but controlling your own destiny is the key to building defensible cash flow.  Starting your own business is also the quickest way to generate are large income (if things work out).
• Community-Driven Websites - Online properties that generate their own content such as forums are often low-maintenance cash cows for their owners.  Community focused blogs, while a bit more work, can be equally lucrative.  You would be shocked how much money a well-optimized blog can pull in.
• Well-Maintained Rental Properties – While perhaps not as lucrative as running an operating business or popular website, investing in quality rental properties is a great defensible way to build a defensible income.  True, the rent you are able to charge is partly determined by the local rental market, but you also have the ability to make shrewd improvements to wring the highest possible rent from your property, even in a down market.

Examples Of Passive Income Streams That Are Not Defensible

Non-defensible passive income streams can be a great boon.  By all means, if you see a lucrative opportunity, take it, but these income streams probably won’t last forever and shouldn’t be relied upon.  They can be a great source of cash to invest in more sustainable ventures, however.

• Time- or Trend-Dependent Markets – The Obama Chia Pet was a brilliant idea and probably made somebody a lot of money, but its days are obviously numbered.  In fact, the novelty has probably already worn off.  I wonder how quickly sales dropped off after the inauguration?
• Sector- Or Income-Focused Mutual Funds – Yes, REIT funds, Financial Sector funds, and equity income funds are all great sources of passive income, but the financial crisis taught us the perils of being too concentrated in any one sector of the market.
• Niche Websites With No Community Component – As lucrative as they can be, niche mini sites depend heavily on the search engines for traffic.  One false step and your site will be dead in the water.  Building dozens of sites on a variety of different topics helps to mitigate this problem somewhat, but you’re still walking on thin ice if this is your only strategy.
• Any Other Income Source Dependent One A Small Number Of External Entities – Any income source dependent on a single external entity (Google, the local commercial real estate market, etc) is bound to rise and fall with the fortunes of its dependency.  This is fine if you spread your bets around, just be aware your income from any one of these sources is far from secure.

Finally, The Key To Financial Security:  Compounding

I bet you saw that one coming, didn’t you?  Einstein was right:  compound interest truly is the 8th wonder of the world.  Consider the following (entirely realistic) example:

Assume you toil for a few months on the internet and manage to get to where you can reliably generate $100 per month in passive income.  Nothing special, but it’s a start.  Now suppose you reinvest that $100 every month into new passive income streams (or into reinforcing your existing streams) and are able to increase your monthly passive income by 50% each year.  This is not at all difficult to do, when you think about it.  After a year of hard work, you would be earning approximately $150 per month.  After two years, $225 per month, and so on.  But look what happens after 6, 7, 8, 9, or even 10 years!

• 6 years – $1,139 per month!
• 7 years – $1,708 per month!
• 8 years – $2,563 per month!
• 9 years – $3,844 per month!
• 10 years – $5,766 per month!

After just 10 years of continued effort and reinvesting your alternative income, you would be earning just under $70,000 per year.  What’s more, if you’ve done things right you’ll only be working 10 hours or so per week to generate that income.  What would you do with an extra $70,000 per year?  Could you retire?

But Most People Will Fail

Let’s face it, most people will fail to generate long-term financial security using this or any other method.  Why?  They won’t stick to it.  Or worse, they won’t even get started.  How many of you would give up after 2 years of hard effort if you were only making a measly $225 per month?  I’d guess 99%.  Life is a game you are practically guaranteed to win, if only you keep trying again and again over the long hall.  But most won’t.  Most will fail once and move on to something less damaging to their ego.  Will you?