The National Living Wage is £23,809 for someone working 37.5 hours a week. The FTSE 100 has a 3.23% dividend yield, which suggests an investor needs £737,120 to earn this as a second income.
That’s a big number, but investors shouldn’t be deterred. I think there’s a viable strategy for targeting this kind of return that requires investing less than half of this.
Compounding
Someone who invests £1,000 a month and manages a 5% annual return could have a portfolio generating £23,809 a year within 23 years. And this only requires investing a total of £277,000.
At 5%, a £1,000 monthly investment generates £330 in the first year, but reinvesting dividends can cause this to rise sharply. It can reach £7,319 by year 10 and £19,818 by year 20.
By year 23, someone following this method will have invested £277,000. But a 5% return means the portfolio will have generated £242,000 in additional capital that can be reinvested.
In other words, using dividends to boost a regular monthly investment gives investors a chance of turning £277,000 into something that earns £23,809. That’s the power of compounding in action.
Inflation
There is, however, a downside to this approach. The value of a £23,809 second income is likely to be lower 23 years from now as a result of inflation.
In fact, if prices increase in line with the Bank of England’s 2% target, £23,809 in 2058 will be worth £14,960 in today’s terms. That’s quite a decline.
There’s not a huge amount investors can do to avoid this – inflation affects returns from all asset classes. But there are strategies they can take to try and limit the effect on their returns.
One of these is focusing on shares in companies that can increase their earnings – and dividends – faster than inflation. And the FTSE 100 has some good examples.
Pricing power
One of the best ways of offsetting rising costs is by increasing prices, but a company needs a strong competitive position to be able to do this. And Rightmove (LSE:RMV) is an outstanding example.
The UK’s leading property portal generates more than twice as much traffic as its nearest rival. And that means there’s a strong incentive for advertisers to list there, rather than anywhere else.
That doesn’t make the business invulnerable – a faltering housing market could cause growth to stall and the firm can’t do much about this. But in terms of competition, it’s very hard to disrupt.
Having more visitors attracts more listings, which in turn makes Rightmove attractive to potential buyers. And this position should – in my view – allow the company to grow faster than inflation.
Income investing
The power of compounding means investors with time on their side can aim for higher returns with less cash. That’s an attractive formula.
Investors taking this approach, however, need to be wary of inflation. Over time, rising prices can cut into real returns in a big way.
The best way to try and manage this risk is by focusing on businesses that can pass increasing costs on to consumers. And the most important thing for this is a strong competitive position.
