Investing in the stock market can be a great way to make money. Done well, owning shares can provide a stream of passive income that lasts a lifetime.
As a UK investor, I aim to take advantage of my Stocks and Shares ISA allowance. This lets me invest up to £20,000 without paying tax on the money I make.
The stock market
One way to earn extra income is by starting a business. If I wanted to set up a drinks company, for example, I could come up with a recipe, buy ingredients, make the product, and sell it.
That’s a lot of work, though. It’s also expensive and there’s some tough competition from the likes of Coca-Cola, Diageo, and Fevertree Drinks.
The stock market gives me a way around all of this. Instead of having to set up by myself, I could buy shares in a company that is already established.
With as little as £1, I could own a portion of one of the major drinks businesses. This includes their manufacturing equipment, distribution network, and brand names.
Best of all, I’d own a share of their earnings. Rather than trying to beat big businesses at their own game, I’d sooner join them as a shareholder.
Getting paid
There are two ways that a business can return cash to its owners. One is by dividends and the other is by share buybacks.
Dividends involve a company distributing its earnings directly to its shareholders. Each share gets paid a certain amount.
Paying a dividend is how I’d take money out of a company if I owned the whole thing. Alternatively, a company can choose to use its cash to repurchase its own shares. As a result, the total number of shares goes down. This allows investors to generate extra income by selling part of their investment without reducing their overall stake in the business.
If I owned 1% of Diageo and the company repurchased 3% of its shares, I’d be able to sell 3% of my investment while still owning 1% of the business. My profits would be passive income.
Passive investing
Dividends and buybacks are never guaranteed. A business might decide it has a better use for the cash.
There are a few things that investors can do to avoid a nasty surprise here, though. The most important, in my view, is understanding the company’s overall strategy.
Some businesses aim to use their cash for growth. This type of enterprise is more likely to reinvest its cash internally than to distribute it to shareholders.
There’s nothing wrong with that. But a company that is investing heavily for growth is unlikely to generate significant passive income in the near future.
Other businesses either don’t have opportunities for growth, or don’t need to reinvest their profits to grow. These are the kind of investments I’d target for lifelong passive income.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
