Passive income is one of those sought-after things that everybody wants. Usually, it comes in the form of some sort of business idea that you can set and forget and generate income for a long time to come, not the stock market.
This is a fantastic idea on paper, but it really begins to fall apart in the real world.
See for you to continue making money, you have to be providing some sort of value to the world. If you are selling a product, that product that you keep manufacturing provides value. If you share helpful information online (this blog), the posts you keep posting provide value.
People want some sort of magical way to put some effort in upfront and continue to provide value endlessly with no further input. In 99% of cases, I would say this is impossible.
But not with the stock market.
Why is the Stock Market Different?
Where the stock market differs regarding passive income is that you aren’t the one providing direct value to consumers. Instead, you are the one essentially loaning money to the company with the “promise” of future returns.
The company is the one using your funds to do R&D, hire employees, market their product, and market and sell their product. At the end of this cycle, they make a profit, which you share in through dividends and a rising share price.
This allows you to remove yourself from the day-to-day requirements of running a company but reap the benefits regardless.
Of course, the company will likely be making a greater profit off of the money than you will. Many companies have an operating margin of >20%, whereas you can expect 7-10% returns based on historical data.
The upside is that you are taking on far less risk and far less responsibility to generate those profits yourself. You put in a simple investment and the company handles the rest.
What’s the Catch?
No money-making prospect is absolutely perfect.
The “catch” to this plan is that you are taking on the risk that if the company doesn’t profit as much as expected, or even at all, your investment loses value. It is always possible for the company to recover in the long run, but it’s also possible that it doesn’t. It just depends on the company that you decided to invest in.
You can minimize this risk by properly diversifying and picking solid companies that will very likely prosper in the long run. That is how the majority of successful investors make their millions.
If you are looking for an introduction to the stock market as a whole, check out my post on the basics of the stock market.
This post will show you how and why you should generate passive income on the stock market
What is the Goal?
Obviously, the goal is to make money. Duh. But how?
Well with the stock market, our goal is to select stocks that will go up with the market. Historically, the overall market will increase by 7-10% annually. Our goal is to simply meet this trend by following the overall market.
It’s tempting to expect to beat the market. It feels simple to select the right companies that will allow you to experience greater-than-average growth. But it’s simply not realistic.
A staggering statistic is that 80–90% of active investors are unable to beat the market. This includes professionals who get paid multi-six-figure salaries to do nothing but manage funds that make money. I don’t mean to be rude, but the likelihood that you will be able to do something that none of them can is very unlikely.
It is far more likely that making risky investments for massive upsides will result in losses.
Instead, our goal is to match the market, while making it as passive as possible.
How to Get Started
The first step will be to join a brokerage. A brokerage is essentially the middleman who gives you access to purchase shares of companies and manage those investments.
To find the perfect brokerage for you, I have an entire post covering the best stock market brokerages. Which brokerage you prefer is a personal decision. Take the time to decide what works best for you.
Once you have selected a broker, you need to deposit funds in that broker. These funds will be used to purchase shares of your desired stocks later on. If you go with a brokerage that I cover in my post on the best brokerages, you will be able to purchase portions of shares all the way down to 1$. So don’t feel like you need to put a massive investment in upfront.
What to Invest In?
I am not a financial advisor. Therefore, whatever stock(s) you decide to invest in is entirely up to you.
Speaking for myself, if I were looking to set up an extremely passive investing portfolio to generate passive income, I would simply throw my money into a fund that tracks the overall market. These funds generally track enough high-value companies on the stock market to track the overall market itself.
The most famous of which is the S&P 500, which takes the top 500 companies on the stock market and weights them by market cap. All this means for us is that it accurately tracks the market as a whole.
Another benefit of investing in a fund like this containing hundreds of large companies is that you get diversification. Diversification is a very important concept in any investment, including the stock market. Diversification allows you to be more resilient to huge swings in stocks since that individual stock only makes up a small portion of your portfolio.
For example, if Apple, the company making up the largest chunk of the S&P 500 went bankrupt tomorrow, you would only lose ~6.5% of your portfolio. A pretty minor change for the largest company on the stock market to go bankrupt.
When you buy a fund, you are buying very small portions of every stock in that fund. For example, putting $100 into a fund tracking the S&P 500 is essentially equivalent to buying $6.50 worth of Apple. Then, buying an amount of the other 499 companies equivalent to their percent weight in the S&P 500.
If you are interested in diving more into buying and selling stocks than just purchasing a fund and forgetting about it, check out my post on buying and selling stocks.
Which Fund?
There are many funds that track the S&P 500. These funds may have different goals such as high dividends or removing the weighting by market cap. However, I have seen it to be historically beneficial to stick with funds that track the market without any alterations.
The option I myself purchase the most of is VOO. Some more active funds charge a higher fee to hold their fund, but VOO charges a very very low fee of .03% of your holdings. SPY is another fantastic option that does essentially the exact same thing with the same fee. For all intents and purposes, these two funds are identical.
If you invest in either of these funds, you will receive dividends from each company making up that fund.
Dividends are payouts to shareholders from the company in return for the shareholder taking on the risk to hold shares of that company’s stock.
If you are more interested in earning dividends as opposed to the growth of your stocks for passive income, SPHD tends to be the most popular choice. SPHD prioritizes high-value stocks with high dividends over those with low dividends. It is still tracking companies from the S&P 500, just with a different focus on how to earn money.
Funds are fantastic options for earning passive income as they are very hands-off. For more info about earning passive income through the stock market, check out my post on exactly that.
Why Not Just Go For Dividends?
The thing to be cautious about with dividend funds like that is that they may be tracking companies that have high dividends but aren’t necessarily the best companies. See dividends are a fantastic bonus when you have a solid stock paying them out. However, many not-so-great stocks will give out high dividends to entice investors.
The reason many great companies don’t pay high dividends is that they focus on growth. When a company makes a profit, it could either pay out some of that profit in dividends or reinvest it all back into the company. A really good company with a solid ability to generate a return on invested capital would rather reinvest in itself. It will be able to generate returns for shareholders through a rising share price in the long run, instead of a dividend payout in the short term.
As there are no rules set in stone, there are exceptions to this rule. For example, JP Morgan and Chase (ticker JPM) currently has a 3.03% dividend yield, along with being a long-standing solid company. Just make sure to do your research into whether a high dividend yield stock is still a good pick.
Dividend Reinvestment
Even if you don’t pick a high dividend fund, you will still get dividends regardless. This is because by tracking the S&P 500, many of those companies pay a dividend.
When you receive a dividend, you have two options. Either take that dividend as cash and do with it what you want, buy another stock with it or take it as cash profit, or reinvest that dividend back into the company that paid it to you. For example, if Apple pays you a $1 dividend, reinvesting it would mean automatically buying $1 worth of apple.
Historically, dividend reinvestment generates the highest returns.
Think about dividend reinvestment this way. When you reinvest a dividend, you are increasing your number of shares of that company, even if it’s by a very small amount. Then, the next time dividends are paid out, next quarter or month, you will receive a higher dividend as you own more of the company. This results in more dividends, all compounding your returns.
Dividends are a very powerful second form of compounding along with the growth returns of your portfolio.
Most modern brokerages allow you to turn on DRIP, or a Dividend Reinvestment Program. These programs automate the process of dividend reinvestment so you never have to think about it again.
If you don’t turn on automatic reinvestment, you will have to manually track payouts and use those payouts to buy the corresponding company. Plus, when you see that cash roll in from dividends, it’s tempting to just take it as cash and leave. Take the decision-making out of it by automating the process.
MUST DO: Automated Investments
Our goal here is to make passive income as passive as possible. When it comes to the stock market, there are actually two benefits to this. One is of course that we hopefully make long-term gains without putting in too much continued effort.
However, there is a second benefit here. Many people fail at investing because they initially get excited about the prospect and invest, but in the long term forget to keep up with the habit. We can get around this pitfall though.
Nearly all modern brokerages allow for automatic investments, or at the very least automatic deposits. An automated investment is where your brokerage will automatically initiate a deposit on a given interval (weekly, biweekly, monthly) AND use that money to purchase a predefined amount of a predefined company. An example of this would be an automatic investment of $50 of VOO biweekly every Friday when you get your paycheck.
Automated investments are preferable as they take you entirely out of the equation. You never have to remember to put some money in or use that money to purchase your favorite fund.
If automated investments aren’t available at your brokerage, automated deposits are the second-best option. These will simply initiate a predefined deposit on a predefined interval and leave those deposits as available cash in your account. If this is the route you are forced to go, I would recommend setting a reminder for yourself to invest that money. Cash sitting in a brokerage is no better than cash sitting in a bank.
Pay Attention, but Not Too Much
Please continue to pay attention to your investments even when these automated systems are in place. It’s important to be aware of general trends in the stock market and how this is affecting different sectors and companies. Sometimes, just paying attention can open you up to an opportunity to invest in an individual stock that other entirely disconnected people won’t see.
However, likely the most common reason people fail in the market is fear. Investors see the market fall or hear bad global news and immediately pull out. This is exactly why the market tanks if there is uncertainty in the world, such as a global pandemic or the housing market bursting.
You may feel like you are timing the market better than everyone else, but chances are you aren’t. There are people out there hired to do nothing but make money on the stock market who can’t successfully time the market. Instead, they focus on investing in companies that they feel will result in the highest gains possible.
Work to find that balance of checking on your portfolio that allows you to know what’s going on without getting scared by the day-to-day natural fluctuations of the market. These fluctuations are natural and expected.
Best of luck on your passive income journey on the stock market!
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