For many of us, passive income is the reason we invest. We may not need the income right now, but we’re building a portfolio that can deliver a healthy revenue stream, when required.
The problem is, many of us just don’t have a portfolio that’s large enough to generate life-changing passive income. In fact, the average net wealth of someone in my age group — 30-34 — is just £14,500.
Even when invested in some of the highest yielding stocks on the FTSE 100, that £14,500 could only generate around £1,200 a year. Clearly, that’s not a life-changing amount of money.
So if I was targeting let’s say £20,000 a year in passive income, how could I do it? Let’s take a closer look.
Step 1
I’ve got to realise it’s going to take time. To generate £20,000 a year in passive income, I’d need £250,000 invested in stocks paying an 8% dividend yield. I’m saying 8% because, right now at least, I believe that’s the highest sustainable yield achievable.
But getting to £250,000 isn’t going to be easy.
Of course, I could throw my money at growth stocks like NIO, Moderna, or CRISPR Therapeutics — all of which have an attractive growth story. But this is risky. The promised growth may not be actualised. Most growth stocks fail.
My choice for investing over the long run is a compound returns strategy. This is essentially investing in dividend stocks, and reinvesting those dividends year after year. The pot grows quicker each year, and benefits if I can commit to regularly investing in it.
So if I invested £14,500 in dividend stocks, and achieve an annualised returns of 10%, after the first year I’ll have £16,000. That doesn’t sound spectacular, but the growth rate increases over time. Nevertheless, it’d still take 28.5 years to turn £14,500 into £250,000.
Step 2
I can expedite the process by investing regularly. This is a great strategy because it allows us to smooth out the peaks and troughs of the market.
So using the above model, when contributing £400 a month and increasing that contribution by 5% annually, it take me just 14.5 years to reach £250,000 as long as my investments perform (which they might not, of course). That’s more like it.
Step 3
Using the above calculation, I’m aiming for a 10% annual return — that’s actually less than the annual returns of the FTSE 250 in recent decades. So by being a savvy investor, and utilising a value-investing strategy, I reckon I can do better than just 10%.
Value investing is a strategy that focuses on stocks that are undervalued and under-appreciated by the market. Warren Buffett, perhaps the most famous of all value investors, tells us to be greedy when others are fearful and fearful when others are greedy.
So for this strategy I’m picking stocks like Lloyds, Barclays and Phoenix Group. All of these offer sizeable dividends — between 5%-9% — and appear significantly undervalued. If I could achieve 12.5% annual returns, it could take me just 12.5 years to reach £250,000.
Step 4
Finally, I’d want to use my ISA because dividends earned in its wrapper are tax-free. I need to appreciate that I can lose money. This is a strong strategy, but nothing is guaranteed in investing.
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.
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.
