The main reason I buy shares is to produce passive income to fund a comfortable retirement when I finally stop working. It’s the job of a lifetime. Or rather, a working lifetime. This means the earlier I start, the more money I can potentially make.
With time on my side, even relatively small, regular sums can turn into something substantial, but only if I stick at it.
Let’s say I was 25 years old and ready to start building an investment portfolio of direct equities inside a Stocks and Shares ISA. As little as £1 a day could lay the building blocks for a terrific second income stream.
I’m investing for dividends
Investing £1 a day adds up to £365 a year. That isn’t very much, and ideally, I’d want to put away a lot more than that. If it was the maximum I could afford today, I’d aim to increase it by 10% a year, every year. Over time my wealth would roll up, thanks to the power of compound interest.
I’ve given up buying FTSE 100 trackers. While the index has delivered a solid long-term average return of 7% a year, I can turbo-charge my dividend income by targeting ultra-high yield stocks like HSBC Holdings (LSE: HSBA).
HSBC may seem an odd choice today, given that the China-focused bank’s share price dropped 8% on Wednesday (21 February), following a $3bn impairment on its stake in China’s Bank of Communications. Over 12 months, its shares are down 5.22%.
These things happen to companies, especially big multinational blue-chips. Earnings and profits do not rise in a smooth upward curve. One piece of bad news can hurt. Yet this is often the best time to buy them, and that’s the case with HSBC.
The board announced a $2bn buyback last week, something investors ignored in their rush to sell. The stock now yields a stunning 8.1% a year, covered 1.9 times earnings by earnings. The forecast yield is even higher at 10.7%. This thrashes the FTSE 100 average of just 3.9%. As if that wasn’t enough, HSBC shares look dirt-cheap trading at just 6.5 times earnings.
Compound interest works magic
By targeting a balanced mix of similar high yielders, I’d aim to generate average dividend income of 7% a year, with any share price growth on top. Now let’s say that by doing so I generated an average total return of 9% a year.
By the time I reached retirement age of 68, my £1 a day (uplifted by 10% a year, remember) would have grown to £778,352. If my portfolio was still yielding 7% a year, that would give me a passive second income of £54,485 a year. Which is huge.
Naturally, there are no guarantees. My portfolio could undershoot. Also, the real terms value of that income will have been eroded by inflation. And HSBC comes with as many company-specific and sector-wide risks as other banks.
Despite these variables, I think the underlying principle stands. By investing small regular sums and increasing them whenever I can, I hope my retirement is going to be a lot more fun than if I invest nothing at all.
