I’ve just done a quick search online for passive income ideas and an eclectic range of suggestions appeared. One of them involves starting a vending machine business. I can see the appeal here, as the cost to start such an enterprise appears to mainly consist of buying the machines and stocking them. Then I just collect the money from the transactions.
Obviously there’s also maintenance work, restocking, and some research involved to find prime locations. But I can see the attraction. That’s probably why stock-picking legend Warren Buffett did something similar as a teenager, investing $25 to buy a pinball machine in 1946.
A much more popular passive income idea is that of dropshipping. This basically boils down to reselling goods without having to warehouse any stock or fulfil customer orders directly. Again, sounds nice, in theory.
Dropshipping income doesn’t seem very passive
Due to the extremely low barriers to entry in the dropshipping space, competition is very high. That means hundreds or even thousands of businesses may be offering the same product as mine. That means I’m going to have to pay for and optimise advertisements to find an audience for the product I’m selling.
Plus, I’ll need to cultivate customer relationships and encourage future orders. And for whatever reason, it’s almost inevitable that a few customers will want to return products. That could create headaches coordinating with the actual supplier.
All this sounds like a lot of work to me, which I’m guessing isn’t what most people really want when they look into dropshipping.
Indeed, passive income is classified as “unearned income” by the Internal Revenue Service in the US. But deriving money from a dropshipping business I’ve built after much effort and thought doesn’t sound unearned to me. It sounds like the fruits of my labour (probably a lot of it).
However, when I receive my regular dividends from the likes of McDonald’s and Legal & General, it’s unearned. It is passive income. Assuming nothing causes the business to reduce or cancel its payout (which is always a risk with dividend stocks), the money just semi-regularly appears in my trading account.
I can use this passive income to help fund my lifestyle. Or, more often than not, I reinvest these dividends and buy more shares. These additional shares can go on to generate me even more income. And on and on, like a snowball, until the returns begin to compound.
Warren Buffett: a lifetime of compounding
The ‘Oracle of Omaha’ has often said that his wealth can be attributed to the power of compounding returns. He bought his first stock on March 11, 1942, when he was 11 years old. But a remarkable fact is that he has generated over 90% of his wealth (estimated at over $100bn) since he turned 65.
His holding company, Berkshire Hathaway, regularly receives increasing dividends from investments he made literally decades ago.
Now, it’s unwise to just buy a bunch of random stocks and expect passive income. The businesses need to have valuable products or services, robust earnings, and strong competitive positions. And not be extremely overvalued.
So there is some investigative work involved upfront. But once I’ve invested in quality companies with these characteristics, any income they pay me is genuinely passive.