Income shares are one of the best ways to generate a passive income, in my opinion. While they come with some risks, investors with modest sums of capital can leverage the power of compounding to achieve some lucrative results. And in the long run, it’s possible to create the equivalent of a second salary without having to lift a finger.
The power of compounding
On average, households across the country are saving around £180 a month. It’s generally a good idea to use these savings to build a solid emergency fund within an interest-bearing savings account. However, for those fortunate enough to already have a large cash cushion, it may be smarter to start drip-feeding this capital into income shares instead.
Looking at the FTSE 100, the index has historically generated an average annual return of around 8%. That’s both ahead of inflation and average savings interest rates offered by banks. At this level of return, drip-feeding £180 each month can build up to a substantial pile of wealth in the long run.
After 30 years of regular investing, a total of £64,800 would have been poured into a stock portfolio. But thanks to compounding, the actual value of this portfolio would be just under £270,000. And for those able to wait another decade, the snowball effect becomes clear since the valuation would reach as high as £628,400!
Following the 4% withdrawal rule, that’s the difference between a passive income of £10,800 and £25,136 per year. That’s why so many financial advisors recommend to start investing as soon as possible.
Risk versus return
Waiting three to four decades to hit a five-figure passive income target is a big ask. Even more so, considering a poorly-timed crash or correction could easily extend the waiting time. While a few investors may have this level of patience, others likely want to get rich quicker.
When it comes to investing, becoming a millionaire overnight is near impossible. The few extremely rare occurrences give novice investors a false sense of hope. However, that doesn’t mean there aren’t strategies investors can deploy to accelerate the wealth-building process.
The first and simplest is to allocate more money to investments each month. Getting a promotion, switching jobs, and cutting spending are all viable strategies to increase the amount of spare capital available at the end of each month.
Investors can also strive to build more wealth with higher returns through stock picking. Instead of following an index, a hand-crafted portfolio of individual top-notch companies can potentially deliver market-beating returns.
This does carry significantly more risk and demands a far more hands-on approach. But even achieving an extra 2% gain can have a significant impact. In fact, doubling monthly contributions to £360 and hitting a 10% annualised return is enough to cut almost 12 years from the waiting time to reach £600k.