Turning 5% of my earnings into £58,460 of additional income every year!

We’ve all got different ways we’d want to use an additional income. We could put it towards holidays, or maybe just use it to help with bills or school fees.

For most of us, creating that passive income is the hard part. But it doesn’t have to be that way. In fact, when we understand the process, it’s a lot easier than most of us think.

Contributing

Many of us in the UK sadly don’t have much or any money set aside to invest. So today I’m looking at how I could start investing with an empty pot.

Well, once I’ve open an investment account, ideally an ISA as returns are tax-free, I’m going to commit to contribute just 5% of my earnings in order to create a portfolio that could generate many times greater than what I put in.

For the purpose of this calculation, let imagine that I earn £2,000 a month — that’s somewhere near the UK median. And then I’m going to invest 5% — £100 — of that every month.

And because I’d hope my hypothetical salary to rise in line with inflation, or better, I’m going to increase that contribution by 5% annually, meaning after the first year, my £100, become £105 a month.

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. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Important concepts

By investing regularly — monthly — and over a long period of time, I’d hope to benefit from two important investment concepts. The first is pound-cost-average. This is the notion that by investing monthly rather than in a lump sum, I can look to even out the peaks and troughs of the market.

The second is compound returns. This is the process of earning interest from on initial investment as well as the interest you earned before. It works when we reinvest our returns every year, or we invest in companies that reinvest on our behalf.

It might not sound like a winning strategy, but it’s one of the strongest investment strategies out there. And it would allow me to turn £100 a month into a sizeable pot. The longer I leave it, the quicker it grows.

Making it work

Of course, the strategy wouldn’t work if I invested in stocks that are destined to fail. In fact, I’d quickly find myself losing money rather than making it.

Instead, I need to search high and low for the right stock, doing my research and running discounted cash flows to check I’m getting value for money. If I invest well, I could expect anything from 6% to 12% in annualised returns.

So here’s how much money my portfolio could generate using the aforementioned investment strategy, and £100 a month that increases in line with inflation.