The beauty of investing is you get to choose your own adventure. There are many vehicles, options, and strategies at hand that you can call upon to grow your wealth and achieve your financial goals. One popular approach is passive investing. When it performs well, passive investing can make your money work hard for you – so you don’t have to. It’s a favourite among the Pearler community, allowing investors to set up a passive income stream that can potentially grow over time without the need for constant attention. Passive investing also embodies the set-and-forget philosophy that many busy long-term investors adhere to.

No matter where you are in your investing journey, understanding the different passive income strategies can help improve your investment portfolio. In this article, we’ll guide you through five investing strategies to potentially generate passive income . Each strategy offers unique benefits and can be a valuable part of your investment toolkit. Let’s explore the different ways you can invest to earn passive income .

1. Dollar-cost averaging: a steady path

Dollar-cost averaging is where you invest a fixed amount into assets, like a high-yield savings account or exchange-traded funds (ETFs) , at regular intervals. These regular investments happen regardless of the asset's price. The benefit of this strategy lies in its simplicity and the discipline it teaches investors.

Potential benefits

• Reduces market timing risk: By investing regularly, you avoid the pitfalls of trying to predict market highs and lows, which can be both stressful and risky.
• Smoothes out price volatility: Investing the same amount regularly buys more shares when prices are low and fewer when prices are high. This tends to average out the cost over time.
• Encourages consistent investing: New investors can get into the habit of saving and investing without needing large upfront capital.

Potential drawbacks

• Lower returns in bull markets : During long market upswings, dollar-cost averaging may lead to lower returns compared to investing a lump sum at the beginning of the period.
• Transactional costs: Regular purchases can mean more transaction fees. This can eat into your investment returns, especially if your broker charges high fees.

Dollar-cost averaging in action

Sarah, a secondary school teacher, decided to start investing with dollar-cost averaging. Five years ago, she began investing $500 each month into a diversified investment fund. During her first year, the market experienced some downturns. In one such month, the price of the fund was $50 per unit, allowing her to purchase 10 units with her $500. In another month, the price rose to $100 per unit, and her same $500 bought her only 5 units.

Even with these fluctuations, Sarah continued her regular investments without attempting to predict the market. By the end of five years, she had invested a total of $30,000. Thanks to purchasing more units when prices were low, her average cost per unit ended up lower than the market's average price during this period. Her portfolio now shows not only significant growth but also benefits from a well-balanced average cost. This shows the effectiveness of dollar-cost averaging for long-term investing.

Of course, Sarah's five-year period could have coincided with more bull markets than bear markets. However, this fictional case study offers an insight into how dollar-cost averaging can work. For long-term investors, dollar-cost averaging can offer a steady way to build wealth gradually while mitigating some of the risks associated with market timing. If you prefer a hands-off approach but still want to take advantage of market opportunities as they arise, this could be the strategy for you.

2. Buy-and-hold strategy: patience in investing

The buy-and-hold strategy involves buying stocks, ETFs, bonds , or other assets and holding them for an extended period, regardless of market fluctuations. This approach is favoured by investors who believe in the long-term growth potential of their investments.

Potential benefits

• Compounding growth : Holding investments long-term allows earnings to generate further earnings, which can significantly increase the value of the investment over time.
• Tax efficiency: In many jurisdictions, including Australia, long-term investments often benefit from lower capital gains taxes than short-term trades.
• Lower costs: This strategy typically incurs fewer transaction fees and management costs, as it involves less frequent buying and selling.

Potential drawbacks

• Opportunity costs: By committing to hold investments for the long term, investors might miss out on short-term gains from other potentially lucrative opportunities.
• Market risk: Long-term holdings are vulnerable to systemic market risks over extended periods, including economic downturns and shifts in industry dynamics.
• Liquidity concerns: Assets tied up in long-term investments can be difficult to sell quickly without potentially selling at a loss.

Buy-and-hold strategy in action

James, an IT consultant, invested $20,000 in shares of a well-established technology company with a strong market presence. He believed in the company's potential for long-term growth, despite its occasional dips in market value. While the company's performance could have suffered, in our fictional example, James' belief paid off. Over the next 10 years, the tech industry saw significant advancements. As a result, the company’s stock price soared due to its innovative products and market expansion. James held onto his shares through various market cycles, and his initial investment grew to $100,000. His patience and trust in the buy-and-hold strategy allowed him to gain substantial growth without the stress of active trading.

The buy-and-hold strategy offers a less intensive approach to growing wealth through long-term investing. It takes advantage of the power of time and the expected increase in the value of quality investments. However, as highlighted above, and as with all strategies, there are risks to it. This strategy may be suitable if you prefer a passive role in daily market movements and believe in the long-term fundamentals of your investments.

3. Dividend growth investing: building income over time

Dividend growth investing focuses on buying shares in companies that not only pay dividends but also have a history of increasing their dividend payouts. This strategy targets companies that demonstrate financial stability and commitment to returning value to shareholders. However, it's important to note that dividends are never guaranteed, and past performance isn't an indicator of future returns.

Potential benefits

• Growing income stream: Investors may benefit from receiving increasingly larger dividend payments, which can outpace inflation and enhance purchasing power over time.
• Compounding effect: Reinvesting dividends to buy additional shares can accelerate portfolio growth, compounding the benefits.
• Reduced volatility: Companies that regularly increase dividends tend to be financially healthy and less volatile, providing a more stable investment environment.

Potential drawbacks

Dividend growth investing in action

Linda, a retired nurse, decided to focus on dividend growth stocks to earn passive income. She invested $15,000 in a diversified basket of dividend-growing companies across the utilities and consumer goods sectors. Over the years, the dividends provided her with regular income stream and also grew annually, allowing her to cope with rising living costs. After 10 years, Linda’s annual dividend income had doubled, and the original investments had increased in value.

As with our other fictional examples, this case study offers a best case scenario. Even so, it showcases the principles of dividend growth investing.

If you’re seeking steady income in retirement, dividend growth investing can offer a compelling balance of risk and reward. It’s a long-term investing approach that aims to provide ongoing income that grows over time, alongside potential capital growth. Dividends are however taxed at an individuals' marginal tax rate, and therefore talking to a tax accountant is advised for this strategy.

4. Dividend reinvestment plans: maximising your investment

Dividend reinvestment plans (DRIPs) allow investors to automatically reinvest their dividend payouts back into additional shares of stocks or ETFs instead of receiving cash. This strategy promotes the compounding of investments, potentially enabling shares to grow in number over time.

Potential benefits

• Compounding growth: Reinvesting dividends can significantly increase the total value of your investment as more shares accumulate and potentially increase in price.
• Cost efficiency: Most DRIPs offer the option to buy additional shares without brokerage fees, which can reduce transaction costs.
• Automated investing: DRIPs automate the reinvestment process, simplifying portfolio management and encouraging a disciplined investment approach.

Potential drawbacks

• Tax considerations: Dividends reinvested are still taxable as income, which could increase the tax burden for some investors.
• Lack of flexibility: Automatically reinvesting dividends means investors could miss out on potential opportunities to use those funds elsewhere.
• Market timing: Since reinvestment is automatic, it doesn’t consider market timing, potentially leading to buying shares at higher prices.

DRIPs in action

Ghin, a graphic designer, decided he wanted to start earning and reinvesting dividends to boost his investments. With this in mind, he enrolled in a DRIP for an ETF that tracks the performance of the top 200 Australian companies. He started with an initial investment of $10,000 and chose to reinvest all dividends. Over 15 years, his reinvested dividends allowed him to accumulate a significantly higher number of ETF shares, enhancing his portfolio's value as the market grew. Ghin’s disciplined approach through DRIPs expanded his holdings automatically and capitalised on market upturns.

DRIPs can offer a hands-off approach to growing your holdings and leveraging the power of compounding. This strategy is especially suitable if you wish to build your investment steadily and maximise returns over time.

5. Rentvesting: combining flexibility with investment growth

Rentvesting is where individuals live in a rental property while owning another property (real estate) they rent out to tenants. This strategy allows investors to live in their desired area without the high cost of buying there, while still building equity in more affordable rental properties.

Potential benefits

• Lifestyle choices: Rentvesting enables living in areas where the real estate might be too expensive to buy. Investors can then prioritise lifestyle or work location without compromising on property investment.
• Investment flexibility: It opens up broader investment opportunities in real estate. This includes investing in high-growth areas that may offer better returns than areas where you’d prefer to live.
• Tax advantages: Potential tax deductions for property expenses and depreciation can make rentvesting financially appealing.

Potential drawbacks

• Rental vulnerabilities: Living as a tenant means uncertainty regarding lease terms and potential rent increases.
• Property management challenges: Owning a rental property comes with responsibilities like maintenance and dealing with tenants, which can be time-consuming and costly.
• Market risks: Like any investment in real estate, rentvesting faces risks such as market fluctuation and vacancy periods.

Rentvesting in action

Andrea, a young professional, chose rentvesting as a way to enter the real estate market and expand her income sources. She purchased a two-bedroom apartment in a suburban area showing strong rental demand and growth potential. Andrea then rented a smaller apartment in the city, closer to work and social hubs. Her investment property quickly secured reliable tenants, whose rent covered most of the mortgage payments. She also ensured she had a large emergency fund in case the property had any unforseen costs, or if the property wasn't tenanted for a longer period of time. Beyond that, she ensured her budget covered the remainder of the mortgage payments. Over five years, the value of Andrea's investment property rose, while she enjoyed the lifestyle benefits of city living. This strategic approach kept her living costs manageable while building her wealth through real estate.

Like all investments, property investment can come with risk. However, for long-term investors, rentvesting can offer a strategic way to grow your real estate portfolio while living in a location that suits your lifestyle. It can appeal to investors looking to balance investment growth with quality of life.

Wrap up – choose passive strategies that work for you

Successful long-term investing can benefit from a passive income strategy that aligns with your financial goals and lifestyle needs. The five passive income strategies we've explored each offer unique advantages and challenges. As a long-term investor, it’s important to understand these differences and how they might impact your investment journey.

Before committing to any passive income strategy, conduct research and consider your own financial situation. Investment advice from a qualified adviser can also give you personalised insights and help you navigate the complexities of the market. By staying informed and seeking expert guidance, you can make educated decisions to manage and grow your investments.

Remember, the right passive investment strategy isn't just about earning passive income – it's about finding the best fit for your personal and financial goals.