The phrase ‘passive income’ is one of the most popular investment search terms of all, as more people recognise the importance of generating a regular stream of money to live on in retirement. The days when people thought the State Pension would be enough have long passed.
Some try to build a passive income by investing in buy-to-let or building up a business. Personally, I’d prefer to invest in a Stocks and Shares ISA. The great thing about shares is that they allow me to start building wealth from day one with minimal cost and effort.
I don’t invest in shares to get rich quick. I’ve learned that the process of building a sizeable portfolio takes decades. I invest small, regular sums, and expect them to grow into something much bigger over time.
I’m taking years over this
I started investing seriously when I was in my early 30s. Ideally, I should have started in my mid-20s, but I had other things on my mind. Mostly nonsense, as it turns out. However, at 30 there’s still ample time to build a large enough savings pot to generate a comfortable retirement income.
Let’s say I was 30 again (I wish) and started investing £250 a month in the FTSE 100. Now let’s assume I increased my contribution by 5% a year, to keep up with inflation. Also, that I invested in the FTSE 100 and matched its average long-term return of 8% a year, with all dividends reinvested.
Given all that, by age 68 I’d have built up an investment portfolio worth a pretty meaty £1,321,898.
I would have made total contributions of £323,129 and generated £998,770 in compounding share price growth and dividend income. I’d have more than tripled my stake, which isn’t bad. The downside is that my £1.32m would have less spending power than it does today, due to inflation.
I’m following the rule
Under a financial planning model known as the 4% rule, if an investor takes 4% of their portfolio as income each year their pot should never run dry. By following this rule, my £1.32m portfolio would generate income of £52,876 a year in retirement. And I should still be able to give my kids a decent inheritance.
As I said, this involves starting at 30. If somebody started investing £250 a month at age 40, they would £508,354 by age 68. That’s less than half the amount, despite applying all of the above assumptions. This underlines the importance of starting early.
It’s still well worth having, though. It will generate passive income of £20,334 a year, using the 4% rule. That’s a lot better than nothing at all.
Naturally, my assumptions can’t be wholly relied upon. The FTSE 100 could return less than 8% a year. Or it could return more. I try to outperform the index by purchasing individual stocks, but as ever with investing, there are no guarantees. The market could always crash just before I retire.
My sums are fairly crude but they do highlight an underlying principle. The stock market is a great way of generating long-term wealth, and a great way of generating a blockbuster passive income too.