by Paul E. Zimmerman

Created on: March 11, 2007   Last Updated: April 13, 2007

Since making my first forays into all things financial years ago, I very quickly grasped the concept of "passive income," income earned not from selling one's own labor, but income generated from invested capital; in short, gaining current income without present work, but from past work. For someone who values his or her time, the appeal of this concept should be obvious.

Despite the advice of those who I like to refer to as the "growth gurus," investors who chant the age-worn admonition to invest aggressively for growth when you're young and save income investing for your retirement years, I've always gravitated toward income. I'm young now, and the way I see it, the sooner I can replace my income earned through labor with "free" income, the better. I want to have more free time when I'm young and able to enjoy it, not when I'm old and faced with limited options due to a decreased physical capacity.

For most of the time that I've been enamored with the concept of passive income, and following the advice of authors of several books on the subject, I focused upon bond investments of various types. The reason for this, and the rationale most of these authors operated upon, is that bonds generally deliver stable, predictable income and safety of principal, which can be recycled into a new bond for more defined income when the original bond matures. At face value, this approach makes sense. The largest potential downside of this approach is the uncertainty of future interest rates - when bonds mature and their capital is ready to be reinvested into new bonds, interest rates could be far, far lower than they were when the original bond was issued.

Investing in dividend paying common stocks, on the other hand, is an idea almost universally discouraged by these authors. The basic reason had to do with the possibility that a company could go out of business, cut its dividend, etc.

The more I investigated the pro's and con's of the situation, the more I realized that the advocates of bonds were greatly oversimplifying the difference. While common stocks can become completely worthless, this is not the inevitable fate of every publicly traded stock. Additionally, dividend paying stocks offer an advantage that, to my mind, bonds simply cannot beat: rising dividends. The coupon rate (the interest) paid on a bond is fixed, but the yield (dividends divided into price per share) of common stocks is not. Like a bond, the purchase of shares in a company, in terms of each purchase,

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