True ‘passive’ income means being paid for doing nothing once an asset has been bought or produced. In my mind, very few things can really be included in this definition. Owning buy-to-let property, for example, is anything but fuss-free if you have regular maintenance issues and problematic tenants to deal with. What’s more, buying a house or flat usually requires a mortgage (a liability) and a hefty deposit to begin with.
In sharp contrast, although it’s never guaranteed, the stock market is about as close as I think anyone can get to earning money for very little output beyond taking a few simple steps. So how do I do this?
1. Cut back (regularly)
I reckon many people don’t get started with investing because they assume they need a lot of cash to do so. However, the truth is I can crack on with relatively little seed money.
Today, I’m using £25 per week as an example. Of course, the actual amount will vary from person to person and depend on a whole host of factors. However, I think that’s achievable for a lot of people. Yes, it could mean one less takeaway a week or skipping the daily coffee shop trip and making a brew at home. Notwithstanding this, knowing such sacrifices can genuinely lead to me earning money while I sleep more than makes up for it.
Getting into the habit of putting £25 aside every week will give me £1,300 every year to invest. Over 10 years, that becomes £13,000 in savings. At this point, such a pot of cash could deliver hundreds of pounds in passive income on an annual basis. That might pay for a family holiday or similar treat. Naturally, a far higher sum could conceivably be achieved if the weekly saving amount were £50, £100 or even more.
2. Open a Stocks and Shares ISA
Of all the five steps mentioned today, this one is right up there in terms of importance. If I’m looking to build a passive income stream, it makes absolute sense to do so using a Stocks and Shares ISA. There are two reasons for this:
- I won’t pay any tax on any passive income I receive
- There are no restrictions on me withdrawing this money
Contrast this with a Lifetime ISA or SIPP (Self-Invested Personal Pension). While both of these accounts offer tax benefits, holders are heavily penalised if they try to withdraw any cash before they reach a certain age. A traditional ISA is far more flexible and allows for income to be spent if so desired.
3. Buy the best passive income stocks
The next step is choosing stocks to buy. Since the goal is to produce passive income, companies paying dividends should be prioritised here. Dividends are simply a proportion of the profits a business makes that are returned twice a year (or sometimes every quarter) to loyal holders.
Unfortunately, not all dividend stocks are created equal. The best are those that offer a decent but not excessive payout that’s consistently hiked, usually every year. Examples from the UK stock market that I’d pick out include defence giant BAE Systems and insurance firm Legal & General.
If a dividend yield looks too good to be true, it probably means the market doesn’t expect it to be paid. As a rough rule of thumb, anything over 6% usually pushes me to do some extra research. A very high yield may be due to a company’s share price falling heavily, perhaps due to a slowdown in trading. In such a situation, I’d need to be confident of things recovering. If they don’t, that chunky dividend may be slashed or axed.
Of course, nothing in investing is guaranteed anyway so it makes sense to buy a selection of income stocks rather than just one or two.
3. Keep costs low
An alternative to the above is to buy what’s known as an exchange-traded fund. This tracks the returns of an index — a big group of shares. An example would be the iShares Core FTSE 100. Not only does this spread my money around lots of very different companies, it also pays a respectable (and so far reliable) dividend.
Another option would be to hand my cash over to a professional fund manager who specialises in picking income stocks. The only problem here is that they often charge hefty fees.
Regardless of which approach I use, buying dividend-paying shares or funds frequently usually isn’t very cost-effective. Picking up shares of the aforementioned BAE Systems, for example, would cost me roughly £10 each time in commission. That’s 40% of my weekly savings!
With this in mind, I’d take full advantage of any ‘regular investment’ schemes offered by my Stocks and Shares ISA provider. As it sounds, this allows me to invest every month, usually at a far lower cost than that mentioned above (maybe around £1, but with some providers it’s free). As experienced investors will know, limiting costs is one of only a few things within our control. However, it can make a huge difference to our eventual returns. The less money I spend here, the more I can put to use buying assets that eventually pay me.
Investing regularly but cheaply also avoids the temptation of trying to ‘time’ the market. Buying a stock for a lot less than it’s worth during a market crash is plainly great. That said, it’s not the most important thing for a passive income seeker. Moreover, it’s very hard to do in practice when everyone is panicking.
5. Do nothing
Aside from buying reliable dividend stocks (or a fund or two), there’s very little I need to do to lock in true passive income. In fact, investing is one of the few things in life where doing nothing can often lead to better rewards.
The key thing for me to remember here is that a lot of firms offering financial services depend greatly on effective, persuasive marketing. I’m encouraged to act because it generates fees, even if that action might not be to my benefit. In reality, there’s simply no need to watch my portfolio rise and fall and rise in value. After all, the whole point of investing for passive income is to make money while using my time more productively.
One final point. In this article, I’ve talked about passive income with the view to spending it. However, if that income isn’t needed to pay the bills and the odd treat, it’s a great idea to reinvest it back into the market and benefit more from compounding — the secret sauce for fantastic long-term returns from the stock market. That’s the Foolish way.
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Paul Summers has no position in any of the stocks 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.