The Importance of Diversification: Part 2

This is part 2 of a two-part series where I discuss the importance of diversification in finances. In part 1, we saw the importance of diversification when it comes to investments and how the risk mitigates by selecting investments from various asset classes, sectors and geographical regions. This article will focus on the diversification of income. 
Income is the single biggest factor in wealth build up. To ensure that the build up can accelerate or simply to protect from unforeseen circumstances, you can employ various strategies to protect yourself from risks which could affect your future earnings.
What is diversified income?
Diversification of income can come in various forms. Income is generally classified as active income when you have to work for it and trade your time for a monetary compensation. This is usually the largest source of income in a person’s life. Secondary active incomes can be added by working part-time, what is generally termed side hustles in the media. A passive income is an income that is sourced without or minimal input from you. Investment income is generally a common source of passive income but there are plenty of other sources. I have discovered that passive income can be a grey area on the active-passive scale and depends on the source and the type/method. I have captured the various forms and ranked them in what I call Passivity Index.
Diversified income sources provide with many benefits. If you are married or living with a partner, having both partners earning brings income diversification immediately and protects you in case of emergencies such as temporal or permanent loss of employment. It comes as no surprise that married couples tend to be richer and separations/divorces have the exact negative effect – taking one of the worst tolls on personal finances.
Why diversify?
The popular saying of “Never put all eggs in one basket” not only applies to investments, but also to income. The need to diversify arises not only to mitigate risk due to external factors but also as a cushion for better living standards. Some reasons to diversify income are:
  1. Unforeseen circumstances such as job loss, disability, death of partner. This could be devastating financially and emotionally. Ensuring that your income is diversified can protect you from such factors.
  2. Financial independence: A diversified income can provide you with financial independence.
  3. Freedom to indulge in your passion: Like it or not, a majority of the people end up in professions which they do not like, or simply dislike the work environment or lifestyle. Alternatively, even if they loved something early in their career, tastes change and people long for career changes or the need for something different. A diversified income source allows people to dip their toes or quit their job allowing them to follow their passions.
  4. The health factor: It is not just about the wealth though. Being financially secure also results in a healthier lifestyle. Various studies have concluded that income and social status are the highest determinant in the health of a person and family. There are multiple explanations for the reasons including: reduced stress, better diet, better access to health & medical care, safer neighborhoods, more free time for exercising etc.

Have you diversified your income sources? How dependable are your side hustles and/or passive income streams?

Passivity of Income

Regular readers of this blog know that I employ various sources of passive income to achieve financial independence. Passive income is a powerful mechanism where I make my money work for me. Since there are various ways to generate passive income and there is always a question of passivity of the income source, this post delves deep into the methodologies and assigns a passivity index to each method.

This article was inspired by a post from FIFighter where he discussed the passivity of each income method and explored how much time needs to be dedicated per week. In this post, I build on that idea with more sources of passive income covered, and explore other details such as the relative risk and reward of each system. Note that these are the risk and reward numbers as per my personal opinion and may differ for each individual. I employ a scale of 0-10 for the risk-reward system, where 0 indicates no risk or no reward and 10 indicates max risk and max reward.

Keep in mind that the following discussion pertains only to passivity of income for each method. By that measure, Income Methods such as Internships & Volunteering and Active Jobs have no associated risk and reward when it comes to passive income and are thusly marked NA.

Income Method Passivity Index  Risk  Reward
Internships &
-1 NA NA
Active Job 0 NA NA
Royalties-1 1 7 9
Real Estate-1 2 7 8
Royalties-2 3 2 6
Trading 4 10 10
Active Investing 5 8 10
P2P Lending 6 9 7
Real Estate-2 7 7 7
GICs &
Bond Investing
8 3 5
Passive Investing 9 2 8
Savings 10 0 1

-1. Internships & Volunteering

This has a negative index on the scale of passivity for obvious reasons. Working as an intern or volunteering means that you not only not generating passive income, but are also not compensated for your time and effort. However, this does not mean that these are necessarily bad. Internships and volunteering can provide invaluable experience that can benefit you in future career or be beneficial in intangible ways.

Passivity Index: -1
Risk: NA
Reward: NA
0. Active Job
This is your regular run-of-the-mill active job for which you are compensated appropriately. The money you earn as income is directly proportional to the amount of time you put in and depends on various factors such as expertise, experience and negotiation skills.
Passivity Index: 0
Risk: NA
Reward: NA
1. Royalties-1
Royalties-1 is anything that requires immense amount of work upfront. Examples include a book or a patent. If we consider the case of a book, work here involves not only writing the book, but you have to work on negotiating a book deal with the publishers, work with designers, market it with book tours etc. It is for this reason that the passivity index is low on this income method. The risks are fairly high as your book has to compete with a lot of other material out there and can get lost in the noise. But the potential rewards are great. Many writers have been able to retire by simply relying on royalties collected from a best seller book.

Passivity Index: 1
Risk: 7
Reward: 9

2. Real Estate-1
Real Estate-1 includes buying real estate and becoming a landlord to rent and manage the property by yourself. This involves a bit of work as you have to screen the tenants, collect the cheques (the easy part :), act quickly if tenants are missing deadlines for rent cheques, address complaints about the property etc. The risk associated involves ending up with problem houses, having problem tenants, potential of missed income if vacant; but the rewards are great as it provides you with a monthly income and if done right, will result in positive cash flow.

Passivity Index: 2
Risk: 7
Reward: 8

3. Royalties-2
Royalties-2 includes earnings where publishing does not include as much of work upfront. Keep in mind that publishing still requires work, but what I refer to here is where you self-publish or e-publish such as online articles, e-books or blogging. The entry point and the hurdles at the beginning to get started are slightly lower here, but still requires marketing (SEO) and other efforts earlier discussed. In my case, blogging on this site brings me advertising revenue and writing content for third party websites provides me with passive income as well.

Passivity Index: 3
Risk: 2
Reward: 6

4. Trading
This income method involves actively trading on the financial markets, which could be trading stocks, bonds, options, futures etc. Traders buying and selling constantly requires work as time and effort has to be poured into understanding the trade. While not a completely passive method, the risks are extremely high as it requires the trader to time the market, an extremely difficult task, but the rewards are just as great if you are on the right side of the trade.

Passivity Index: 4
Risk: 10
Reward: 10

5. Active Investing
Active investing involves investing in companies that you want to own as a business. This usually involves investing in the company stock and holding it for the long run, with income coming through profit sharing via dividends and distributions. Picking the right companies that can perform well year-in and year-out is the risk involved. Holdings stocks for income can be very rewarding as the dividends start rolling in. As a dividend growth investor, this is one of my primary sources of passive income.

Passivity Index: 5
Risk: 8
Reward: 10

6. P2P Lending
P2P lending involves lending money to another person for a higher than market interest rate, which can be rewarding if the borrower pays back. However, the risk is higher as you have to trust that the person would pay the loan back, and on time.

Passivity Index: 6
Risk: 9
Reward: 7

7. Real Estate-2
Real Estate-2 is similar to Real Estate-1 except that a property manager takes care of all the hassles for a small fee. The property manager acts as a middle-man dealing with the tenant, providing the owner/investor with more free time making this option more passive. The risk stays the same between the two options, but the reward diminishes a bit due to added costs.

Passivity Index: 7
Risk: 7
Reward: 7

8. GICs and Bond Investing
Investing in GICs and bonds can be quite passive and have a passivity index of 8. However, investors have to keep an eye out for macro economic measures and where the interest rates are going. Since the Fed and/or central banks around the world do not change interest rates on a monthly or quarterly basis (even though they meet frequently), the investment horizons are generally in years and decades. The risks are low as it is guaranteed income for the period, but there are risks involved nonetheless. If the interest rates rise, the face value of the bonds can fall. Similarly, GICs locked-in for years can erode your wealth if there is rampant inflation.

Passivity Index: 8
Risk: 3
Reward: 5

9. Passive Investing
Passive investing is where you simply invest in the financial markets using a fund on a periodic basis. Investors using the passive investing method seldom pay attention to what is happening on a day to day basis in the market and prefer buying broad funds that invest in indexes. This is one of the most common methods of investing, be it for beginners or seasoned investors who do not have the time to follow the markets and monitor closely. The risks are mitigated when using broad index funds and the rewards can be great as long as the expenses are kept in check.

Passivity Index: 9
Risk: 2
Reward: 8

10. Savings
Savings accounts provide the most passivity, but also have the least reward. Over a short period of time, the interest generated by savings accounts can be rewarding, but over time the cash loses value as inflation erodes the buying power. The interest paid by savings accounts seldom keep up with inflation. However, there is no risk associated with savings accounts as they are usually insured by a federal agency.

Passivity Index: 10
Risk: 0
Reward: 1

So there you have it. That should provide you with an idea of how to generate passive income and understand the risks and rewards associated with each. I would love to hear your thoughts, comments and/or questions. Feel free to start a conversation below.