Passive income is probably one of the most important financial education topics there is. Before I go through why it’s so important, let me first answer the question "What is ‘Passive Income’?" as this is a bit of a jargon term.
What is ‘Passive Income’?
Passive income is money you earn without working. The most common forms of passive income include:
The interest you get from your savings account,
Dividends from investing in the stock market,
Rent from renting out a property,
Pension when you retire.
The key aspect is that you earn this money whilst you sleep. Not all investments provide passive income. For example, Crypto-currencies (Bitcoin), art, and gold don’t provide a passive income (these investments only make money via the Great Fool Theorem). Also, the home you live in is not a form of passive income as it doesn’t provide an income.
Why is passive income so important?
Essentially, passive income is at the core of many important money topics:
Investing in the stock market generates Passive Income
Compound Interest comes from Passive Income
Being wealthy comes from having a Passive Income
Retirement is only possible when you have Passive Income
Freedom is only possible when you have Passive Income
“If you don’t find a way to make money while you sleep, you will work until you die” Warren Buffett.
We can’t just rely on our pensions anymore
The default for most people is that you work and then retire, at 65-70 years old, with your pension providing a passive income to cover your expenses. Today, we can’t just rely on our pensions. Company pensions are becoming less generous and we are living longer than before. Research by the World Economic Forum shows that the average person in the UK is going to run out of savings 10 to 12 years before they die. This is worrying and likely to be more of a concern for our kids as they are expected to live even longer than us. This means we need to be teaching our kids about generating other forms of passive income, so they have enough money to last their lifetime, and not just be reliant on their pension.
Passive income means freedom
On a more positive note, teaching kids about passive income can lead them to have enough income to cover their expenses for a series of 'mini-retirements’ or to 'retire early for good'. The more that our kids see that money can provide freedom, rather than being used to buy ‘stuff’, the more they are likely to focus on saving and passive income. When I’ve talked about the importance of helping your kids form a savings habit, one of the main reasons to do so is to allow your kids to have money to start generating a passive income. We don’t want our kids to simply save money under their mattress, we want them to put that money to work so they earn more.
How do you teach kids about passive income?
You guessed it … using seeds and trees! As I say to my girls, if money is like seeds and you plant those seeds (save/invest) then they will grow into a tree. Passive income comes from the seeds produced from the trees they have planted. The goal is to plant your seeds so that your forest grows to the point where it produces enough seeds to cover your expenses (spending). Below are some pictures that I used to help show this. First, when you receive some seeds from working, make sure you save some:
Soon, your forest will start to produce seeds (passive income) so you can save more:
Then, your forest will produce enough seeds to cover all your expenses:
Then you are ‘free’!!
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Keep expenses under control
The more you spend, the more seeds you need so the bigger your forest needs to be.
I explained to my daughters that many people when they get pay raises at work, start to spend more and more as they try to ‘Keep up with the Jones’. This means that as they earn more, the forest they need becomes larger. However, as they are spending most of their money (and therefore not planting their seeds), the forest they have isn’t getting any bigger. This isn’t a good situation to be in.
Spending vs. Saving
I never want to discourage my daughters from spending their money. Spending money is fun! It’s all about getting the right balance. As I say to them:
"Have fun spending most of your money, just remember to save a little bit before you start spending”.
If they save and invest, they will start to generate a passive income which allows them to have much more money to spend in the future. Imagine if you had saved £1,000 today. You could spend it now or if you invested it then you’d get £1,000 to spend every ten years for the rest of your life. How? If you invest, it takes, on average, 10 tens to double your money. So, in ten years you’d have £2,000. You could then spend £1,000 and leave the original £1,000 invested. Then repeat every ten years forever. As with all things money-related, the key to success is having patience to wait that first ten years to see the benefits.
The last point to teach your kids is that the earlier they start to plant their seeds, the more time they have to grow their forest. The longer the seeds are planted the more time Compound Interest has to work its magic and the more seeds (passive income) their forest will produce, i.e. one tree produces one seed, and that seed grows into a new tree (2 trees in total), combined those trees produce 2 seeds which grow into 2 new trees (4 trees in total) and so on and so on until you have a forest which is producing many seeds.
If you don’t want your kids to be working until they are well into their 70’s, make sure you teach them about Passive Income. Passive income is using your savings to earn an income whilst you sleep. Help your kids start to generate a passive income by setting up an investment account for them today. If you are new to investing then please read this blog and then follow our 3-step guide to opening an investment account. Help other parents teach their kids about the importance of passive income by sharing this blog - even telling one friend can make a big difference. Thanks for reading! Will
P.S. Some people say that side hustles like running a YouTube channel, affiliate marketing and creating an app are forms of passive income. Whilst they can provide an income once set up, they aren’t exactly passive. I’ll explain further in a future blog so make sure you have subscribed. Make sure you now read …
How to teach your kids about the stock market (a form of passive income)