Investing in shares can be a good way to earn some passive income, in my opinion. Bank interest rates are low, so I’m always looking for where else I can park my money.
Investing in shares involves greater risk compared with putting money in a savings account, of course. But I’m comfortable with additional risk for the additional returns I could potentially get.
Regular investments
To earn a passive income from shares, I’d first set up a regular monthly investment. The stock market can be volatile at times, and it’s sometimes psychologically difficult to buy shares when prices have fallen a lot, even though that’s often a good time to buy. An automated monthly investment buys shares without the need to think about it and helps to smooth out the peaks and troughs.
On average, a diversified selection of global shares has achieved a return of 8%-10% over the long term. Of course, past performance doesn’t guarantee future stock market returns. But as the historical period is many decades, I’m going to use it in my example.
I calculate that by investing just £200 per month at a rate of 10% per year, I might be able to build an investment pot of shares worth £265,367 over the next 25 years. Let’s say at that point, I’d like to withdraw an annual passive income.
Going with the industry standard, I should be able to withdraw 4% as income every year without denting on any of the original capital. That annual passive income would be £10,615. Again though, this isn’t guaranteed.
What to invest in first?
Once set up, I’d need to decide what to invest in. With a long investment period of 25 years, I would choose growth stocks in the earlier years. I’d look for fast-growing companies that could become much larger in the coming decades.
Ideally, they’d demonstrate double-digit sales growth, have large total addressable markets, and be disruptors in their fields. And growth stocks don’t have to be minnows. Companies such as Paypal, Nvidia, and Amazon come to mind.
An alternative to picking individual shares is to pick well-run managed funds or investment trusts. Growth-focused funds I currently like include Scottish Mortgage Investment Trust and Fundsmith Equity.
A word of warning, however. Fast-growing shares can be more volatile and can be prone to booms and busts. That said, this risk can be mitigated with a long investment time frame.
In the latter years, I’d switch strategies and look for lower growth but dividend-paying shares.
Passive income from dividends
Passive income from shares can come in the form of dividends. This share of company profits can provide relatively regular income. Many companies pay dividends quarterly.
That said, dividends aren’t guaranteed. Even regular dividend-payers experience shocks to their business. For instance, when Covid-19 hit, many businesses suspended dividend payments. Some have since reinstated them, but others are yet to resume payouts.
Therefore, it’s good to be picky when it comes to creating a passive income from dividends. I like to find companies that have a decent track record of providing consistent dividends. For instance, at least five years of payouts. I also like companies that can sustainably pay for dividends from cash flows.
Although there are dozens of options, some dividend-paying shares that I’d add to my portfolio include UK housebuilder Persimmon and mining giant Rio Tinto.
