Some investors view the stock market as a get-rich-quick scheme, but I prefer to take the Foolish approach — namely, thinking like a long-term investor. In fact, it’s possible to generate a sizeable second income over time by investing as little as £250 a month in carefully selected dividend shares.
Here’s how I’d aim for this goal starting from scratch.
Building wealth slowly
One key advantage of investing for the long term can be found in compound returns. Essentially, this is the cumulative effect of ‘earning interest on your interest’.
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The investing phenomenon is so powerful that Einstein reputedly dubbed it the “eighth wonder of the world”. Whether the Nobel Prize winner actually ever said this is a moot point. But, he wouldn’t be wrong if he did!
To illustrate the long-term impact compounding can have, let’s imagine I invested £250 a month for 35 years. If I secured an 8% compound annual growth rate on my stock market positions from dividend reinvestments and capital gains, here’s what my journey could look like.
| Time taken | Portfolio value |
|---|---|
| 5 years | £18,362 |
| 10 years | £45,343 |
| 15 years | £84,986 |
| 20 years | £143,235 |
| 25 years | £228,822 |
| 30 years | £354,576 |
| 35 years | £539,352 |
Portfolio drawdown strategies
Accumulating wealth is only half the story. Developing a sensible withdrawal strategy when the time comes is equally important.
After 35 years of investing £250 a month, I could have a portfolio worth just shy of £540k. At a 4% dividend yield, that would provide me with a little under £21,600 in distributions every year. Not too bad for an entirely passive second income!
But, what if the dividend yield across my stocks fell below this? The 4% rule for retirement, devised by William Bengen, suggests it’s sustainable to sell stocks to cover any shortfalls — at least for a 30-year retirement.
In essence, an investor can withdraw 4% of the starting value of their portfolio in year one of the withdrawal phase. They can then adjust this number to account for inflation every year. In doing so, it’s possible to make financial plans around an established second income figure.
Risk management
However, it’s important to note the 4% rule was tested against a specific portfolio. Bengen assumed a retiree would be invested 50% in the S&P 500 index and 50% in intermediate term Treasuries.
Some UK investors may wish to adopt a different portfolio composition to minimise currency risk or pursue active investment goals.
The exact make up of a portfolio depends on an individual’s risk tolerance. After all, stocks are notoriously volatile assets. In order to mitigate the impact of share price falls, investors should consider diversifying their positions across different companies and sectors.
In addition, including bonds in a portfolio when approaching retirement can reduce volatility risk. But, this may come at the expense of reducing overall returns.
Whatever the chosen approach, investing in stocks for the long term is a wealth-building tool that has stood the test of time. For as little as £250 a month, earning a sizeable second income is a realistic ambition after years of dedicated investing.
But, prudent investors should always be alive to the risks. After all, there’s no such thing as a free lunch.
