I think inflation is a real risk for the UK at the moment. And one of the best ways of trying to combat this could be figuring out a way of earning a second income.
Warren Buffett says the best defence against inflation is being the best at something and the second best is owning shares in a quality business. I don’t see why people can’t look to do both.
Passive income
A lot of businesses distribute part of their income to shareholders as dividends. And this provides people that own shares in these companies with a source of cash that’s genuinely passive.
After buying the stock, there’s nothing else to do – just wait for the share of the profits to arrive (although profits aren’t guaranteed). So investors have all of their time available to work on other ways of increasing their income.
This is different to starting a business from scratch, or buying a property to rent out. Both of these involve significant amounts of work, which can cut off other potential ways of making money.
There’s also an issue about competition. If I wanted to try and start my own operation, I could find things difficult – or even impossible.
The stock market
The best thing about the stock market is that it allows investors like me a chance to own part of some of the best businesses in the world. This includes companies like Lloyds Banking Group (LSE:LLOY).
The bank makes money by making loans and earning interest on them. And the regulated nature of this type of industry means I could never realistically hope to set up an operation like this by myself.
This is a competitive business and customers are mostly influenced by price, which means Lloyds can’t easily charge higher rates than its rivals. But it does have an important competitive advantage.
What separates the best banks is being able to pay less interest on the cash it uses to make its loans. And with the largest consumer deposit base in the UK, Lloyds is in a stronger position than its rivals.
Strategic investing
Of course, there are risks with Lloyds. Its competitive position is strong, but there are some things – like the possibility of a sudden change in interest rates – that could still weigh on profits.
Lower interest rates usually mean narrower margins. But a sharp rise in rates is also a risk, as savers expect better returns on their deposits instantly, while loans are mostly at fixed rates.
There isn’t really a way around this for Lloyds – it’s the kind of risk that has to be managed, rather than avoided. And for investors, the best way to do this is by building a diversified portfolio.
Owning shares in businesses that are less exposed to interest rates risk can limit the overall effect on a portfolio. And the stock market offers a lot of opportunities for diversification.
Dividends
At today’s prices, Lloyds shares have a 4.7% dividend yield. And for a business with advantages that are difficult for competitors to copy, I think that’s quite attractive.
The bank’s sensitivity to interest rates means I think investors should consider it as part of a diversified portfolio, rather than as an investment by itself. But that’s why the stock market is so valuable.
