The idea of earning something from nothing sounds pretty good to me. That, in a nutshell, is what passive income is all about.
Here’ I’m going to explain how making a small, daily sacrifice now can really pay off in time.
Passive income: worth the sacrifice
Let’s start with the bad news. To generate passive income, I need to raise some money to begin with. On a more positive note, this doesn’t need to be very much at all. One commonly used example is shunning the shop-bought daily coffee on the way to work.
Let’s keep things simple. A £3 daily expense means £15 is spent on coffee every workweek. That becomes a staggering £780 over a year.
Now let’s assume I invested this money in the stock market via a Stocks and Shares ISA at the end of the first year. Let’s also assume that I continued adding to this every month. For ease, we’ll go with £60 (20 coffees) per month.
Assuming an average return of 7% from the market, that grows to £11,482 after 10 years. Not bad at all. After 20 years however, this becomes £32,535. After 30 years, it’s almost £74,000!
The calculations above are clearly just a guide. While returns from the stock market tend to be better than I can get anywhere else over the long term, they can’t be guaranteed. They could be lower… or higher.
But what about the passive income bit?
Don’t worry – I’m getting to that. One thing worth remembering is that many investments pay dividends, usually twice a year. Indeed, over the long term, these make up a significant proportion of the total market returns.
Right now, the dividend yield from the FTSE 100 index is 3%. That’s already far more than anyone I’d get if I put my coffee savings into a Cash ISA. However, some individual companies pay a lot more. Since these would be held in a Stocks and Shares ISA, there’s no income tax to pay either!
The only thing to mention here is that dividends can be cut in times of trouble. As such, I’d buy a selection of dividend stocks from different industries, rather than just one or two to reduce this risk.
It’s also worth highlighting that what an investor does with this passive income can have a huge impact on performance. Assuming I have no need to spend it, my best option would be to reinvest what I receive.
There’s a simple reason for this. Throwing the money back into the market allows me to buy more shares. Owning more shares allows me to benefit to a greater extent from compounding over time. As the years pass, this could really improve my returns.
No coffee? No problem
Obviously, this example won’t work for those who don’t need daily caffeine hits. Nonetheless, the goal here is to show how saving a few pounds every week can help generate a passive income.
I don’t need to quit coffee (that’s a big ask!). But I reckon investing the equivalent amount will seriously boost to my wealth.
Adopting this approach won’t make me the next investor billionaire Warren Buffett, but it might provide me with a decent nest egg for retirement.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.