This week I talk about an important topic: Active and Passive Income!
VIDEO SUMMARY
I thought I would make a video on active income and passive income. And I thought this was especially relevant, because I have been making several videos about how “Focus” can be an effective business strategy. I have been making these videos during an interesting time, because the most common business advice right now is “Diversify your income.” You will hear this phrase from all kinds of business gurus. How can I be making videos about focus, when everyone else is telling you to diversify your income. The reason for this contradiction has to do with the difference between active and passive income. So it is important that you understand the difference.
Let us start by talking about the definitions of active and passive income. Active income means transactions based on effort. Passive income means transactions that require little or no effort. These are very general definitions. If you are dealing with taxes and the IRS, they have very specific definitions for active and passive income. But I am more interested in a general definition from a strategic sense of the difference between active and passive income.
Let us look at some examples. Active income would be things like salaries, billable hours, and service contracts. Here you are doing actual work, and billing for that work. Passive income would be things like royalties, rent collected, online revenue, investment income. These are things where you could do nothing and have money drop into your bank account.
When you present these two options to most people, they tend to get excited about passive income. Why would someone do all the work of active income, when you could do nothing and have money drop into your bank account. Passive income sounds very attractive. But of course there is a catch.
Passive income comes with a lot of risk that active income does not have. Let us compare the difference between active income and passive income. With active income you have control over your income. If you do good work, you will make good income. Whereas passive income you have very little control. You are not doing anything, so you completely rely on swings in the market, changes in technology, and the mood of your customers. Another difference is that since active income requires work, that creates a barrier to competition. Whereas passive income, since there is no work required, there is low barriers to competitors coming in and stealing your market share. The final difference I want to point out is with active income there is an opportunity cost to diversification. If you are working at a job, it is very difficult to diversify and get a bunch of other jobs to diversify your revenue. Each time you split your focus you pay a price for the time you take away from your other jobs. Whereas passive income, has limited opportunity cost to diversification. Since it does not require any effort, you can split your time among many different things.
The common thread here is that there is a lot of risk with passive income that is not there with active income. So it makes sense to have two different strategic approaches for active income and passive income. For active income, it makes a lot of sense to focus, because you experience an opportunity cost when you start to split your focus. For passive income, it makes a lot of sense to diversify to mitigate your risk. I actually made a video on diversification, you can search for it on YouTube. A good example of this is when you are investing in the stock market. It is a really good idea to diversify because you do not have control over the outcome of those income streams.
I want to end with a historical perspective. This advice to “diversify your revenue” has not always been the most common piece of business advice. You hear this phrase all the time now, but it has not always been this way. If you read older business books, they do not spend a lot of time telling you to diversify your revenue. I would say this has really become a popular piece of advice over the last decade. I think it is important to understand what is happening here. In the last decade, we have seen the emergence of Web 2.0. This is what is referred to as the growth of social networks online. What this created was an opportunity to build online businesses based on passive income. This could be from ad revenue or websites you could create sales without having to do anything. Well, like any passive income stream, these businesses carry a lot of risk. And over the last decade, a lot of these business owners have been burned by their passive income suddenly dropping from forces that were outside their control. These bad experiences are what is driving everyone shouting at the top of their lungs to “diversify your revenue.” The point I want to make is really that advice applies to a very specific type of business situation. It is important to analyze where you want to go with your business. Do you want to rely on active income or passive income? That is going to help you develop an appropriate business strategy.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.