The Complete Beginner’s Guide to Passive Income (2024)

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Tags: Financial Freedom, Passive Income

It may not seem like an inherently “SuperHuman” skill to earn money while you sleep. However, it's important to understand that “passive income” – or the ability to completely detach your work output from your earnings or income – represents mastery over both your finances and your time. If you look at it this way, then understanding and “hacking” the process of earning a living becomes one of the most important and impressive of SuperHuman skills.

It is for this reason that I began exploring passive income in the early 2000's, along about the time I read The Four Hour Work Week. It took me nearly 10 years, dozens of trials, and a whole lot of learning before Imastered the system and gained full control over my financial future. For this reason, I'm very excited to share a post I originally wrote for Medium.com about a year ago. In my opinion, it's a pretty in-depth explanation of passive income, applicable to both novices (“wait, what's ‘passive income' mean?”) to advanced practitioners. Most importantly, it gives you a number of concrete examples of my own passive income endeavors, which hopefully can spur your creativity and motivate you to get out there and do something with it. I've added a few notes to update it, since a lot has changed and evolved in the last year.

It's a very long read – but has been deemed well worth it by the Medium community.

And so, without further adieu…

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The Complete Beginner’s Guide To Passive Income

Or “How I Make More Money By Not Working Than I Did By Working”

Since graduating from business school, a lot of people have begun asking me what I’m doing, or if I’ve found a job. The answer is almost always “working a few hours a week on some side projects until re-launching my startup.” Whereas this may sound like an unfortunate or undesirable outcome, it’s not so bad… My gross income now — without really “working” on anything — is higher than it was when I was working 80 hour weeks running a $3M/year eCommerce company. It’s not glamorous, but it’s all part of a strategy. Let me explain…

Passive Income: What it is and Why You Want It

Like many, I was first really turned on to the idea of passive income by Tim Ferriss. In The Four Hour Work Week, he describes the system he developed with BrainQuicken, where the marketing, shipping, reordering, banking, and even customer service of the company was on complete auto-pilot. I found this idea intoxicating. The idea that Tim could travel the world learning to tango and staying on private islands while money just accumulated in his bank account seemed like some strange fiction — surely, this isn’t how people actually live, is it?

Well, no. That type of lifestyle is a pipe dream, and for good reason. Setting up passive income takes work, maintenance, and constant reinvention. But we’ll get to that. The more pertinent question is why.

The point of passive income is to liberate your time for more fruitful endeavors —whatever those may be.

Most people who set up passive income don’t do it so they can lay on a beach all day, or even so they can spend their time learning a third or fourth language (ok, maybe I’m doing that), or living on private islands. No, the point of passive income is to liberate your time for more fruitful endeavors —whatever those may be. If you have the ambition and gall to get out of the “9 to 5 game” and set up passive income, chances are you won’t be happy with sitting on your butt or traveling year round. You’ll want to do something with meaning and purpose. For Tim, that was learning and writing a series of books, which he’s truly passionate about. For me, that’s traveling, learning, and working on startups that are “high risk” or have a long road to generating revenue. For you, maybe it’s spending time with your kids and not having to take overtime when it’s offered to you. In any case, my goal is to spend as little time as possible to cover my basic needs; if I want to spend more time to make more money, that’s always an option — but I want it to be an option, not a necessity. As of right now, this is working out brilliantly. Because I have passive income streams set up, I don’t have to worry about generating sales immediately, raising funds from investors so that I can eat, etc. But I didn’t always have passive income — in fact, it took a lot of trial and error and a lot of learning (do yourself a favor and read Rich Dad Poor Dad — iBooks Link Here) before I had anything worth mentioning.

My Governing Laws of Passive Income

I’m not sure how other people look at passive income, though I’m also not sure I’ve innovated anything here. My thinking on the matter is a hybrid between 4HWW, RDPD, and a general understanding of business strategy and economics, reinforced by my time at Berkeley and INSEAD.

Let’s start from the basics and lay down some general laws about passive income.

Money is made where value is created and exchanged,

where “value” is defined as some benefit that people are willing to pay to receive. Seems really basic, right? But most people don’t seem to get this basic step. Any time anyone makes money in any way, value has been created and exchanged. In a way, we are all value-creating assets. It’s how we make money. Nothing wrong with that. The problem is how most of us create value.

Nearly every “9 to 5″ worker (nothing against them) is a service worker. The definition of a service is a commodity where the value is created and consumed at the same time —think massages, for example. They create value — inputting purchase orders, serving customers, managing employees, etc — for a company or employer. The employer then consumes these services simultaneously. (An interesting side note: I recently realized that by definition, a company is only going to hire you if they can sell the value you create for more than it costs them to obtain. In a way, this means that any time you’re employed, you’re getting a raw deal). The books are pleasantly organized, customers served, teams managed, etc. The problem (in my mind) is that this is hugely time intensive and easily capped. Income = Time x Value, where Time is a finite resource limited to 24 hours a day (or, more realistically, 12).The way most people address this is to change the second variable. They get a law degree, MBA, or PhD, making their time worth more money. This works swell… but it’s still limited. At some point, you’re that lawyer making $550/hr, but your income potential is capped, as willingness to pay more is at it’s highest, and no new time can be created. What to do?

Value that can only be consumed once isn’t very valuable at all

You are valuable. Your time, your work, knowledge, experience, and output are all valuable. In fact, your employer (or your customers, if you’re an entrepreneur), probably pay a lot of money to rent these things from you. The problem is, whether you’re a doctor, a lawyer, an artist, an engineer, or even a baker, the value you create is consumed once — then it’s gone. You can only sell a loaf of bread once. You can only sell each open heart surgery to one client. The value trades hands, and now it belongs to the customer — you get paid once.

As we’ll see, one of the key tenets to passive income is to break this relationship; to create value that can be amortized and repeatedly sold, rented, or otherwise traded again and again and again.

Value has to originate from people, but it doesn’t have to be delivered by them

At some point in every value chain, value has to be created by a real human. No argument there. However, who says that a human has to deliver that value? Some very smart humans put in the work to create Google, but for the most part, they don’t have to do any work to deliver value to you, whether it’s search results or GMail or Maps. Your landlord put in a lot of work to afford the apartment you live in, to remodel it, and even to find you as a tenant. But now, he doesn’t have to do any work to deliver value to you: you wake up every morning in the apartment whether or not he works.

Passive income is defined as income-generating activity that is independent or loosely dependent on time commitment. Just so we’re on the same page, here, there’s no such thing as making money without creating value (I wish), and creating value takes time and effort. So, you are technically transacting time for money, in a way. But passive income is where we separate or at least alienate the proportional relationship between time spent and money made. It’s where there is no longer a fixed ratio, and if there is, it’s not a 1:1 ratio, but more like a 10 or 20:1 ratio of man-hours-worth-of-time to actual time. As another side note, knowing how much your time is worth both to you and on the open market is a valuable piece of information for guaging how effective your passive income activities need to be.

The Three Types of Value Exchange

Fortunately, there are only so many ways to skin a cat, er, deliver value. If you look at just about all economic activity, you’ll see that it breaks down into a few categories.

Selling Value

The term “selling” probably doesn’t need much explanation, but it’s where value is transfered one time in exchange for money. Heart surgery, baguettes, and designer jeans are all ways to sell value. This one would probably the least optimal of all, at least for passive income, if it weren’t for an exception. This is because once you sell a normal commodity or service, you can’t re-sell it. Here’s the exception to this: software or digital goods can be duplicated with a very low marginal cost(now that we don’t use CDs, you can duplicate it with a cost of $0.00), and therefore, technically can be “sold” advantageously over and over and over again. This is why Microsoft grew to such a profitable company, and why I love selling digital goods.

Renting Value

Renting value is exactly what you do when you go to work every day. This is a great way to adhere to our rule against one-time consumption, although you can only rent something to one person at a time (drawback). By renting something, I can generally avoid degradation of the value, or at least lessen it. By renting you a house, I’m charging you for the value of the shelter and comfort, and in fact incur pretty minimal decrease in value as your usage of the house causes wear and tear. When you’re done renting the house, there’s still plenty of value left to rent out, and the fact that you’ve enjoyed a year or two of value doesn’t much matter to the next willing consumer.

Creating secondary value — generally advertising potential — and then selling or renting that

Note that the mechanics of selling and renting here are the exact same, the difference is that with secondary value, we’re going to create another form of value, and we may or may not charge to exchange both forms of value.

That’s confusing, so let’s take a simple example. I create a free newspaper, and give away the value (information, entertainment) to people at no charge. By doing so, I’ve created a powerful form of secondary value: the attention of my readers. I then rent this value out to advertisers, who consume it regularly. If an advertiser leaves and I find a new one, the fact that the other advertiser consumed value before is of little or no concern to the new consumer.

That’s it. If you can think of another way of delivering value, I’d be interested to hear it. Governments create value and deliver it in this way (selling you the services of the FDA in exchange for taxes, for example). There’s no “magical” fourth revenue model.

That’s it.

But don’t worry, it works to our advantage.

Engineering Passive Income & Examples

Knowing that there are only so many ways to create value, we simply have to look at the cost/benefit of each one and be selective about how value is created.

Plain and simple, we have to create or buy valuable assets, preferably ones that deliver their value automatically.

Instead of working in the service framework, passive income necessitates that we build (or otherwise acquire) something that inherently contains value, which can then be easily and repeatedly transferred to others with little or no work. Plain and simple, we have to create or buy valuable assets, preferably ones that deliver their value automatically. There are a lot of ways to do this, but they all fall into the 3 categories above, and realistically, a lot of them look like different flavors of the same thing.

Think about the value you rent out or own . Then put it into something that can be sold or rented more passively.

I’m somewhat embarassingly reminded of Harry Potter and the concept of “Horcruxes” here, in that the goal is to find a piece of your value, and impart it into an inanimate object or product, Voldemort Style (did I really just make a Harry Potter reference?) Anyways, whatever. If you want passive income, you have to think about the value you rent out or own. Or, you need to buy something valuable that other people would like to use (I love the idea of a 3D Printer). Then put it into something that can be sold or rented more passively. Maybe you have a car that sits in the driveway, or a vacation home that is empty half the time. Maybe you just have some funny jokes you could put into a YouTube video and run ads on. At some point, you have to “transfer” the value into something that can work for you — that something is an asset.

Let’s look at some different assets that can be harnessed to make money, and understand how they work.

Digital Goods, Software, Information Products, Stock Photography, Music Loops, etc.

This encompasses everything from eBooks to stock images and even Udemy courses. The idea here is to create a digital good that has value. Why digital? Well, if you’re creating really unique hand-made socks, you can’t just duplicate them and resell them. Furthermore, you have to pack and ship each pair. Both of these things mean that there’s a fixed ratio of labor to income, and we’ve already discussed why that’s not ideal. Digital goods can be duplicated, and we can engineer systems (or use online marketplaces) to deliver them automatically. Awesome.

Side note: Patents, if you’re smart enough to create one (I’m not), are also great. They require a bit more work and legal hoops to set up, but if a company like Samsung is going to license your patent in one of their products, that is a “set it and forget it” income stream for as long as they need the patent.

Blogs, Websites, YouTube Channels, and other informative materials

This is separated intentionally from “information products,” because here I’m referring specifically to secondary value creation. If you can write a popular blog and get people reading it, you can sell ads. Alternatively, if you write a niche blog about vegetarian, gluten-free cat food, you can use special affiliate links to different websites, and get paid when people buy through those links. There’s lots of great blogs making tons of money doing these two things (I know of people making millions referring credit card signups), but please note that unless someone is writing and distributing the content for you, this is not passive income. It takes a lot of work to drive traffic. Some of the smarter people I know doing this have hired content writers and set up a bunch of sites, but they invest a TON of time on SEO, finding the right topics, etc.

Selling actual products

Like we said above, there’s nothing passive about this, but if you can create another type of asset — a system for selling products — then it is. One example is to write a book, and use Amazon Fulfillment Services to automatically print and ship it every time you sell a copy, depositing the money in your account. Another example is Tim Ferriss, who hired overseas assistants to handle everything at BrainQuicken, from the marketing to the reordering. With drop-shipping (having the manufacturer ship directly to your customer), this has become easier, but you should know that it’s still a good bit of human labor to advertise, handle customer service, etc. But, it’s a good option, and you can experiment with automation and delegation as you go along. If you want to know more about this, read The Four Hour Work Week already!

Real Estate and Physical Assets

Though it requires a huge up-front investment (well, at least 20%), real estate is awesome, because it’s (usually) pretty stable, and it’s a triple-whammy: you make money by leveraging a bank’s money, you can rent it out with almost no work at all day-to-day, and the value of the underlying asset INCREASES. This is why so many people flock to AirBNB to rent out their apartments when they’re going on vacation, too. It’s pretty passive, you don’t have to own the asset, and you just hand over keys and hire a cleaner before/after. The value of your apartment is untouched. By contrast, imagine buying a plane and renting it out to people for tours — you pay tons of money to maintain it, and after 20 years, it’s value is almost nothing. The exception is if you can manage depreciation and somewhat automate the value-delivery. If you have an expensive tool (like a 3D printer) and charge people to come over to your house and print things on your 3D printer, it’s pretty passive for you to answer emails and open the door, so I give it a “Semi to yes” for passivity.

Real estate has another perk: Tax law in the US (and most countries) has been written by landowners. There are some ridiculous loopholes, like the ability to deduct expenses (and maybe even some interest) as a cost of doing business. Also, you can sell the property and buy another one without paying taxes. I won’t go into detail here, but Real Estate is my favorite form of passive income, and it makes up over 50% of my portfolio. See the next section for a breakdown.

Traditional Investments

Stocks and bonds and all that good stuff can be passive income, too, but with high investment requirements up front (not unlike real estate). If they’re set up to pay dividends, this is a great passive income generator, because it’s low risk and can hedge out some of the risk you introduce in other endeavors.