Different types of income

Based on requests from readers, I will revisit the different types of income, especially passive income as a clear understanding is necessary if one desires to attain financial independence. I still get many questions regarding where to start an investment journey; the money market or the stock market. Although I have addressed this issue in previous articles on asset allocation and building a solid financial foundation, I will address it directly.

Money market versus the stock market

There is no basis for comparison between the money market and stock market, as they perform different roles in your financial portfolio. The money market belongs to your financial security plan while the stock market belongs to your financial growth plan. You need both plans. I see people fleeing for safety by jumping from the money market to the stock market and vice versa due to market movements.

Your financial security plan is like insurance; you need the cover. Exposing yourself because you want quicker returns is not a smart thing to do. Stockbrokers encourage this behavior in their sales pitches advising clients to move funds from the money market into stocks for higher returns.

It is no news that the stock market delivers superior returns over time compared to the money market. This is the reason why stocks belong to your growth plan. If you put stocks in your security plan, you will lie down in the bed of sorrow when the stock market plunges. Both markets have a place in your portfolio, but the wise thing is to start building from the foundation, not the wall or roof. Building a foundation is a slow process and it can be frustrating. Walls go up faster. If you build without a foundation, the building will still stand.

People can move in and live normally and nobody will know the building has no foundation until a big storm and heavy rains come. That is when you know which building has a strong foundation and which one was built on sand. if you lose your job, that is when you will know that you cannot live on the stock market, unless you want to start selling your shares every month to fund your living expenses, which means the days of your stock portfolio are numbered.

It is this type of advice that made many liquidate their money market investments and even borrow money in 2007/2008 to join the party in the stock market only to get their fingers burnt when the market crashed. Many vowed never to return to the market, fleeing for safety into the money market and real estate market. That fear has kept them away from the stock market which has since rebounded and attracted foreign investors looking for higher yields.

Such skewed advice hurts the stock market in the long run. This is one of the reasons financial illiteracy is very expensive. You cannot outsource your financial education to experts, especially those that have a target to meet. They will sell you advice that benefits them.

Build a foundation of financial security first before aiming for growth. You may do both sides by side but your focus should be on building financial security first. Don’t be led by the rate of return only, but focus on building a robust cash flow. If you ignore the foundation, you will pay dearly for it. It is only a matter of time. Don’t try to be smart and bypass the process.

If you are employed, start from the money market before launching into stocks, other speculative investments or even starting another business. Many have borrowed money to start a business which did not work out, so they ended up with a pile of debt. There are no shortcuts unless you are Bill Gates or Steve Jobs, then you can build from the roof and then use your profits to build a foundation to support the structure.

Types of income

There are two broad types of income – earned income and passive income.

Earned income: This is the income type most of us are familiar with – earning a salary. For many, this is the only way they know. With earned income, you are working for money – essentially trading your time (life) for money. Earned income is essentially ‘no work no pay’. When you stop working, you stop earning.

You are only rewarded for your labor. You cannot hire someone to do your work. You have to do it by yourself. You cannot transfer your job to your son or daughter. Your job is not your personal property.

If you own a business that pays your salary, this is still classified as earned income. You are still an employee, except that you work for yourself aka self-employed. If you don’t show up for work, the business suffers and income goes down.

Passive income: Passive income is the exact opposite of earned income. With passive income, you don’t work for money, your money works for you. You are not trading your life for money, but money for money. Your money does not have working hours. It works 24/7 including weekends, public holidays, and during force majeure (strikes / civil disturbances, etc). It does not go on vacation or call in sick. The asset is yours and can be transferred to whoever you want.

Passive income refers to cash flow from real estate investment, and intellectual property like music, books, inventions, patents, etc. These are assets you work once to create and if well marketed continue to generate income long after you have stopped working on them.

Income from paper assets such as money market instruments (fixed deposits, treasury bills, etc), stocks, bonds, etc is referred to as portfolio income. Again, once acquired, you don’t have to work for them to yield returns. Your money works for you while you do other things with your time.

Different strokes for different folks

The rich focus on passive income while the poor and middle-class focus on earned income. One income type is not better than the other. It depends on who you are and what you really want. What is important is making informed decisions.

If you want to achieve financial independence, then you need to focus on passive income, especially portfolio income. Your job then is to convert your earned income as efficiently as possible to portfolio income.