Investing in UK shares might be one of the best ways to build a passive income. At least, I think so. Why? Because the FTSE 100 hosts some of the highest-yielding dividend stocks in the world.
Even with the disruptions of the pandemic, the index is still expected to yield 4.1% in 2022 – far ahead of the S&P 500‘s 1.37%.
Dividends may be boring versus the excitement of explosive share price growth opportunities. But in the long term, they can become a massive source of recurring income. Take Warren Buffett’s investment in Coca-Cola as an example. In 2021, he earned $672m in dividends alone. After decades of dividend growth, that’s the equivalent of a 52% annually recurring return on his original $1.3bn investment 34 years ago.
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With that in mind, let’s explore how to leverage the power of dividends and compounding returns so that I can eventually say goodbye to my day job.
Reaching millionaire status with UK shares
On average, when dividends are taken into account, the FTSE 100 has generated an annualised return of around 8%. So if I invested a £10,000 lump sum today into a low-cost tracker fund, I could expect to have approximately £10,800 in a year, with around £400 of that gain coming from dividends alone.
Such a performance is obviously not guaranteed, since the stock market is a volatile place. And I may end up with less or even lose money. But let’s assume the historical average continues to repeat itself for the foreseeable future. Under this assumption, after 34 years of compounding at 8%, my portfolio value would grow to just over £136,900.
That’s not bad. But it’s certainly not enough to retire on. And definitely not enough to generate a five-figure passive income. However, if I continue to invest a small amount each month, then things start to get interesting. With an additional relatively small monthly capital injection of £500, my portfolio of UK shares across the same time period ventures into millionaire territory at £1,124,000!
Generating a £45,000 passive income
Assuming the 4.1% dividend yield is maintained, my imagined £1.12m portfolio would yield a £46,084 passive income annually. Stack the State Pension on top, and that sounds like a fairly comfortable retirement, in my opinion.
Obviously, with inflation doing its thing, such a portfolio will be worth less in the future in terms of consumer spending power. And as we’ve seen recently, the stock market does have a tendency to tumble every once in a while as companies endure economic headwinds.
A crash will inevitably happen again at some point. Many UK shares will undoubtedly cut, suspend, or even outright cancel dividend payments in such a scenario. But by diversifying my portfolio, the impact of such events can be mitigated. And by ensuring I have a reasonable amount of cash on the side, these temporary stock market downturns can be endured.
