Building a steady stream of passive income is a financial goal many share. After all, who doesn’t love the idea of making money without needing to put any effort in? There are many ways to go about achieving this objective. Yet, in my opinion, the stock market serves as one of the best methods available.
Not every business is cut out to deliver stellar growth. But those generating a consistent and reliable cash flow often try to satisfy the appetite of income-seeking investors with dividends. And an investor who builds a portfolio of these robust enterprises can enjoy watching the money roll in.
Building a passive income in the stock market
Getting started on an investment journey can be quite a daunting task. There are a lot of moving parts, and with so much white noise online and in the media, it’s easy to get overwhelmed.
Fortunately, there is a simple and proven financial instrument investors can buy to start with to gain long-term success. It’s called an index fund.
Instead of picking individual stocks, investors can simply buy shares in an index fund to match the performance of an underlying index like the FTSE 100. This effectively puts a portfolio on autopilot while simultaneously taking care of diversification and asset allocation challenges.
Historically, the FTSE 100 has delivered an average annual return of around 4%-8%, which originates from dividends. That’s certainly a more impressive passive income than the interest on a savings account. But it does quickly highlight a problem.
If an investor is aiming for a £500 monthly income at a 4% dividend yield, they’d need to have a £150,000 investment portfolio. Needless to say, that’s not exactly pocket change. But reaching this level of wealth is not as impossible as many believe.
Stock picking and accumulation
Making £150,000 overnight isn’t realistic. So how can investors tackle this challenge when aiming for £500 monthly passive income?
One method is to delve into stock picking. This is by no means for the faint of heart and requires much more dedication, emotional discipline, and risk tolerance to succeed. But by custom-tailoring a portfolio of individual stocks, investors can realistically boost their dividend yield to 5%, or even 6%.
That may not seem much of a difference. But at a 6% yield, hitting a £500 monthly income target reduces the portfolio size requirement by £50,000! And assuming this portfolio can match the FTSE 100’s capital gains performance of 4% at the same time, the combined returns equate to an annual gain of 10%.
Suppose an investor were to steadily drip-feed £500 each month at this rate of return? In that case, reaching the £100,000 threshold could be achieved within a decade.
Having said that, it’s important to remember this performance is anything but guaranteed. Dividends are ultimately optional payments for businesses. And they’re often put on the chopping block when economic conditions sour.
Yet, even if dividend payments remain intact, a 6% yield won’t look so impressive if the share price goes in the wrong direction. And as 2022 has perfectly demonstrated, that can and does happen, even to the best companies in the world.
All of this is to say investing is far from risk-free. But prudent decision-making combined with patience can unlock a lucrative stream of passive income.
