The idea of generating passive income from the stock market looks very attractive right now, especially with inflation topping 9% in April. Here are 10 easy steps I’d take to get started.
Get a budget
To generate passive income, an investor clearly needs some money in the first place. This is why having a budget is so vital. Simply making a record of where the cash goes each month can be quite revealing.
Having produced a list of outgoings, the next step is to stick to it for at least one month. After this time has passed, I’d review what’s been spent and whether any money remains once the essentials have been taken care of. If so, then the next step can be skipped. If not, it might be time to make some sacrifices.
Make savings
To be clear, this is not about postponing all pleasure until some random date in the future. It’s about finding out what things are really worth spending money on and where I can obtain them for less. This might involve visiting comparison websites, or changing where I shop.
Finding a spare £50 or £100 a month is a great starting point.
Open a Stocks and Shares ISA
Next on my list of steps is set up a Stocks and Shares ISA. This ensures any money I make in the markets isn’t subject to capital gains tax. More importantly, the ISA wrapper also means any passive income I receive — in the form of dividends — isn’t taxed either.
It takes minutes to set up an account but the long-term benefits it brings are substantial.
Set up regular payments
When opening my own Stocks and Shares ISA, I made a point of setting up a Direct Debit with my bank to transfer a set amount each month to my account. Automating my finances in this way helped to normalise saving. After a while, I simply got used to this money leaving my account on a regular basis, just like any utility bill or subscription.
I also made sure to set the date of transfer to be the first day of every month. Doing this makes it certain that a set amount of money will go to my ISA, as opposed to waiting until the end of the month when cash may be getting tight.
Pick a strategy
For passive income, there are three general strategies. Buy individual stocks, funds, or a combination of the two.
The first is by far the riskiest. Individual company stocks can be volatile, hence the need to hold a sufficient number rather than just one or two. That incurs commission charges which add up over time. On the flip side, there a many stocks paying above-average dividend yields. This strategy will allow me to tap into these.
While there are no risk-free options when it comes to investing, the second option is arguably the one that involves the least stress. Asking an experienced fund manager to pick stocks capable of generating passive income on my behalf involves far less time and energy. Having said this, there are no guarantees on performance. Moreover, funds have ongoing charges which ultimately eat into my returns.
One solution here is to only invest in passive trackers. Since these are managed by computers rather than humans, the fees are usually low. The disadvantage here is that I merely track the return of an index such as the FTSE 100. The dividends are likely to be lower here too.
The third option is a happy medium, if you will. Having a proportion of my money in individual stocks might earn me more passive income than through funds alone. However, also keeping some of my money in the latter should me to sleep soundly at night.
Start investing
Having decided on a strategy to follow, my next move would be to get started. This is easier said than done, of course. The stock market has been a pretty scary place in 2022 so far.
The awful conflict in Eastern Europe has had as much impact as the aforementioned inflation. There’s also no guarantee that things won’t get worse before they get better.
On a far more positive note, I see this as the perfect hunting ground for Foolish investors like me. What can be better than buying stock in quality companies when they’re on sale, especially when dividends are on offer too.
Drip-feeding
Drip-feeding (or ‘pound-cost averaging’, to use the technical lingo) is simply about buying shares in regular installments rather than in one go. This allows me to take advantage if the price of something I want to buy more of drops over time. Obviously, the one risk here is that a share or fund will actually get more expensive rather than cheaper. But predicting this with any accuracy over a short time period is pretty much impossible.
Another benefit to the drip-feeding approach is that it can cost less in fees. Most online platforms charge £1-or-so if I schedule to invest on a particular day in the month — far less than the £10-or-so charge incurred for buying on a whim.
Don’t spend what’s received
Tempting as it has been to splash out on something nice the minute dividends are paid into my account, I know that throwing the money back into the market should eventually lead to a far bigger payoff.
The longer I leave this money invested, the more I’m allowing compound interest to work its magic.
Increase contributions
In addition to reinvesting my dividends, I also know that increasing the amount I pay into my Stocks and Shares ISA over time can potentially turbocharge my returns. This will clearly depend on me being able to earn more and/or spend less elsewhere.
Even so, the incentives are compelling. The more I can invest, the greater the quarterly or bi-annual payouts should be.
Switch off
Regardless of my approach to generating passive income (stocks, funds, or both), I know it’s vital to take a break from the markets.
Switching off from my portfolio after a while is rational for the simple reason that I am never in control of share prices. The only thing I can do is ensure my strategy matches my attitude toward risk.
It’s also vital in the current economic climate. My investment value can fall as well as rise. But there really is no point fretting over paper losses if I don’t intend to sell anything for years.
