The only thing better than generating one-off passive income from the stock market is to make it for life. Some investors feel that as soon as a dividend gets credited to their account, it must be spent.
Sure, the income is there to be enjoyed. Yet to reap benefits for decades to come, a different strategy is needed. Even with a modest amount of £25 a week, it’s possible to enjoy sizeable cash further down the line.
Reinvesting and compounding
Complicated jargon doesn’t impress anybody. Yet to understand why it’s better to save rather than spend, investors need to grasp two concepts.
Reinvesting is when I take a dividend received and buy more shares with it. Typically, it makes sense to put the dividend income back in the company that has just paid it out.
For example, let’s say I save my £25 for a few weeks and invest the £100 in a stock yielding 7%. If I assume an annual dividend gets paid, I’d take the £7 and buy more. I now have £107, which should pay me £7.50 next year.
The process of multiplying my return is known as compounding. Over time, the reinvestment amount grows and grows. It’s a much faster pace than if I simply spent the dividend each time and left my initial capital in the company.
The main risk here is that I might struggle to reinvest at the same yield as before. Let’s say I invest at 7% today. In two years’ time, I could get paid another dividend that I use to purchase more of the same share. But if the yield is only 4% at that point in time, it drags down my average yield.
Building up with £25 a week
Straight off the bat, I’m not suggesting an investment of £25 each week. When we add up all the different fees associated with buying and selling stocks, it doesn’t make sense. Rather, combining the weekly amount and investing once a month, or once every couple of months, makes a lot more sense.
I’ve figured that I’m happy to take the passive income I make for the next 30 years and reinvest it. Then when I get close to retirement, I’ll start to enjoy it. I’m still making lifelong income, but choosing when and where to save or spend it.
If I invest £100 each month with an average yield of 6%, I’ll have a pot worth £101k after three decades. From there, I can stop and enjoy £505 a month in dividend income!
Clearly, I have to be mindful of the reinvestment risk. This could mean my pot is smaller than £101k. I’m also conscious that my financial situation could change when looking out this far. Yet when I’m referring to £25 a week, I’m pretty confident that I can keep up this commitment for the long term.
