There are numerous ideas online about how to make passive income. They range from vending machines to recording audiobooks. However, while many of these sound interesting, I’d rather stick to the proven wealth-building example laid down by Warren Buffett.
A lot of effort
Today, dropshipping is one of the most popular side hustle ideas. This is an order fulfilment method that does not require a business to stock its own products.
Instead, it sells the items online and passes on the sales orders to third-party suppliers, who then ship the orders to the customer. The seller takes a cut without dealing with any stock, which at first glance looks great to me.
However, there also seems to be quite a lot of work involved. There are operating costs for marketing and advertising, maintenance of the site, and constant search engine optimisation (SEO) needs.
Plus, due to fierce competition, there appears to be a lot of undercutting of prices. Consequently, dropshipping margins are often very low.
So this looks like a time-consuming grind to me rather than an effortless passive income stream. The juice just isn’t worth the squeeze, as far as I can tell.
Investing for dividends
By contrast, the cash I get from dividend stocks is totally unearned. Assuming nothing causes the company to axe my payout, which is always a risk, I receive money for simply being a shareholder.
While I can spend this passive income how I see fit, I’d prefer to reinvest my dividends in order to buy other shares. These can go on to generate me even more dividends in future, and so on.
This harnesses what Albert Einstein is purported to have called the “eighth wonder of the world“. That is compound interest, and Warren Buffett’s $100bn+ net wealth is the ultimate embodiment of its power.
Finding stocks with moats
Buffett likes to invest in companies that possess what he calls an ‘economic moat’. Like around a medieval castle, a moat stops competitors from invading and stealing away market share.
The most obvious example is a brand moat. Companies that have very strong brands often enjoy customer loyalty, making it very difficult for new entrants. They also have pricing power to preserve profit margins.
Two examples would be Coca-Cola and McDonald’s. Coke has boosted its annual dividend for 61 consecutive years, McDonald’s for 47 years.
These are the type of dividend stocks I’d aim to build a portfolio around.
Generating passive income
Buffett’s investing record since he took over Berkshire Hathaway in 1965 is truly extraordinary. He has returned an average of 19.8% per year, which is double the market average.
He has done so by taking the long view. Stock market volatility doesn’t scare him out of his investments, which means they have all the time necessary to grow in value.
To build towards big passive income, I’m also going to have to take a long-term view of investing.
Finally, the great news is that I don’t have to replicate Buffett’s incredible record in order to build an impressive sum. An 11% annualised return on £500 a month would get me to £404,638 after 20 years.
From this, I could earn £32,371 in annual passive income if my portfolio was collectively yielding 8%.
