Updated: February 24, 2021
Learning how to invest is an important part of becoming financially free. Good thing that it’s not that hard to start investing today.
However, many fail to understand how investments work, particularly, in terms of how it makes money.
At the most basic level, your investment income comes in three forms. First, as capital gains; second, as earned (or active) income; and third, as passive income.
Knowing the differences between these three, and being able to analyze how each of your investment earns, can be a valuable guide in achieving balance in your investment portfolio.
Investments are often categorized by their risk type – almost zero, low (conservative), moderate, and high (aggressive).
A time deposit, for example, is an almost zero risk investment. Assuming the bank won’t close, and without considering inflation, then your money will always appreciate.
Meanwhile, with the other three, your money can go either up, or down. The level of risk dictates how much your investment could potentially gain (or lose).
Income from Investments
Now let’s consider the three forms of income you get from investments:
1. Capital Gains
These are investments that you buy because you hope that their value will go up in the future so that you can sell them for profits. A good example of this would be the income you get from investing in toy collectibles. Your time deposit account is also an example.
2. Earned Income
These are investments that you buy because they have the potential to give you income BUT ONLY if you would actively work for it. Enrolling yourself in a baking class is an investment of both time and money, and it will give you earned income in the future, by selling cakes and cookies for example.
3. Passive Income
These are investments that you buy and “forget” because these give you income regardless if you work or not. A good example would be dividends from investing in a private company or the income you get from a business that’s running on its own.
The Critical Investing Mistake
Wealth managers would often say that you should diversify your portfolio. This simply means spreading your investments across zero, low, moderate, and aggressive types of instruments. And that’s just what many people do.
When investing, many forget to consider the form of income one gets from an investment. This is the one critical investing mistake that you might not know you’re making.
Investing in instruments that give capital gains and earned income may not be enough to help you achieve financial freedom. You need passive income to make everything else happen.
Having a time deposit account, a moderate-risk mutual fund investment, and stock market shares certainly looks like a risk-diversified portfolio. But when it comes to income-type, all three primarily just give you capital gains and very, very little passive income.
It’s the same thing with having an office job, running an online store business, and freelancing on the side. You’re doing pretty well when it comes to having multiple sources of income, but all three are mainly earned income types.
Investing in capital gains secures your future, but it does not pay your bills today. Meanwhile, earned income does pay your bills, but it could drive you to exhaustion in the future.
The Importance of Passive Income
Investing in passive income does not only pay your bills today but also gives you the time freedom to do more and enjoy life more.
Lastly, I’m not saying that investing in capital gains and earned income is bad. I actually think you should always and regularly invest in those types of income.
What I am saying is that you should not forget to invest in building passive income as well. You should invest in assets that give you regular cashflow, without much active effort on your part.
So the question now is, what are those types of investments that give good passive income? There are a lot, among them are dividends from a business, rental income from properties, and royalty payments.
It’s great that you’re investing, but don’t just focus on growth. Also allot money, time, and effort to building an automatic cash flow machine in the future.