£12,500 in cash? Here’s how I’d aim to compound that into a £8,084 annual second income

This writer explains how he’d go about harnessing the greatest wealth-building force on earth to build a decent yearly second income.

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The internet says Albert Einstein called compound interest the “eighth wonder of the world.” Whether he actually did is debatable (there’s no original source where Albert uttered this). What’s not up for debate, however, is that compounding can supercharge returns and provide a sizeable second income.

Here, I’ll explain how I’d aim to turn £12,500 into a tax-free £8,084 income.

Getting started

Savers in the UK are blessed because we have access to a Stocks and Shares ISA. This vehicle enables £20,000 to be invested every single year without incurring tax.

First off then, I’d put my money into a Stocks and Shares ISA. This opens up the possibility of investing in property through real estate investment trusts (REITs), exchange-traded funds (ETFs), and individual companies by way of shares.

Through such investments, I could look to grow my portfolio at an average rate of 8%-10% a year over the long term.

That’s not guaranteed, of course, as the stock market doesn’t go up in a straight line. It’s just a rough average.

Along the way, there will be volatility, bear markets, and even the odd crash. Therefore, it’s crucial that I adopt a long-term mindset.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.

A mountainous opportunity

So, where would I start putting this cash to work?

Well, I like the look of Schiehallion Fund (LSE: MNTN) today. This is an investment trust with stakes in high-growth private companies that are later stage and have the potential to list on the stock market.

Somewhat unusually, it aims to hold onto these stocks long after they go public. So, for example, it still has Airbnb in the portfolio even though the firm has been public since 2020.

Above, we see the shares cratered in late 2021 as interest rates rose. That’s because higher rates negatively impact private companies that still need financing (at costlier rates).

To be clear, this risk hasn’t gone away. Rates could stay higher for longer if inflation creeps back up. And that could keep pressure on the value of its unlisted assets.

However, looking at the top five portfolio holdings (as of 29 February), most aren’t short of cash.

Portfolio weight
US Treasury12.7%
Space Exploration Technologies (SpaceX)7.2%
Wise5.7%
ByteDance5.2%
Bending Spoons4.8%

SpaceX isn’t about to run out of money and ByteDance (owner of TikTok) reportedly just achieved a 43% year-on-year rise in revenue in Q3 of 2023. That was $30.9bn in around 13 weeks!

So there aren’t cash-strapped start-ups in basements. Moreover, 12.7% of the trust’s assets is in US government debt.

Yet the shares are currently trading at a massive 34% discount to the net asset value of the fund. Once firms start going public again and interest rates come down, I think the shares will do well.

Getting to that sum

Now, let’s assume I invest in a portfolio of such stocks and achieve an average 9% annual return over the long term.

This would transform my original sum into £107,788 after 25 years. From this, I could generate a second income of £8,084 a year if I had dividend stocks paying an average yield of 7.5% a year.

This would be without me investing more money. However, if I choose to do so along the way, my final sum would be significantly higher.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Ben McPoland has positions in Airbnb and Schiehallion Fund. The Motley Fool UK has recommended Airbnb and Wise Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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