How to create passive income to fund essential to luxury expenses

Passive income is a key path to financial freedom. While active income allows you to trade time for money, passive income allows your money to work for you. When your passive income outgrows your expenses at some point, technically you are financially free. Sounds simple enough?

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The challenge for most people is they tend to see passive income as a single source of income. For example, some may invest in dividend stocks and the income from the dividends become a source of passive income. Others may decide to invest in real estate and treat the rental income as a source of passive income. The above is fine, but by concentrating your income stream from a single source, you bear the full downside risk of the asset class. 

The recent stock market correction is a good reminder, where a substantial correction in the markets can cause investors to panic. I speak to clients on managing their wealth on a daily basis, most tend to overestimate their risk appetite when the markets are good, and the fear sets in when the markets start to correct. Similarly for real estate investment, interest rates, vacancy risks and policy risks can affect the stability and returns for investors.

What I suggest for investors is to "Kueh Lapis" your passive income streams. Like the traditional snack with many layers, layering your passive income streams will help to diversify your passive income and create a more consistent and predictable passive income. I like to layer the income streams in order of risks, starting with the lowest risk at the bottom up to the highest risk at the top layer.

Lower Risk

At the lowest layer, you have your bank deposits and cash equivalent. This will generally draw you little interest, but are as stable as it can get. I like to add in other sources of lower risk instruments such as endowments, annuities, bonds and instruments with a certain level of guaranteed income to form the lower layer of income. This layer will buffer against market volatility and create a certain level of protection for the capital and income stream to fund your essential expenses such as food, transport and general living expenses.

Moderate to Higher Risk

The moderate to higher risk layer will provide higher returns and income when markets are good, but may take a hit when market conditions are less ideal. Possible instruments in this layer can include your dividend stocks, real estate investment trusts (REITS), equity funds, real estate investments, etc. The income from this layer can be used to fund discretionary spending such as travel expenses, gym memberships, or other expenses which you can choose to live with or without. 

This will allow you to have the peace of mind your essential expenses are taken care of regardless of market conditions, and your moderate to higher risk layer will provide higher disposable income for you to enjoy life with discretionary expenses and spending.

Highest Risk

Not everyone may be comfortable with the risk for this layer, but the instruments in this layer tend to be high risk high return, with the potential for multi-factor gains and you may lose your entire capital if the markets do not move as what you have in mind. Some instruments in this layer can be options trading, cryptocurrency and other alternative investments such as art, wine, etc. The income from this layer can be used to fund luxury expenses if you desire. 

By layering your passive income streams, you can create a more robust portfolio of financial instruments by diversifying some of the inherent risks of the individual asset classes. As the saying goes, never put all your eggs in one basket. A well rounded portfolio can provide better peace of mind and allow you to continue enjoying your passive income streams regardless of market conditions. Stay safe, stay invested and do consult a qualified financial adviser if you have doubts on how to build you portfolio.

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