Having a chunky passive income is one of the most popular financial goals. Apart from helping to cover everyday living expenses, earning money without lifting a finger frees up more time to spend with family and friends. It can even help secure a more comfortable retirement lifestyle.
There are lots of different methods, such as starting a business, or acquiring rental real estate. And while these can be hugely lucrative, there’s a lot of upfront effort involved with no guarantee of success.
Investing also doesn’t come with guarantees. But the process is far more straightforward and doesn’t require anywhere near as much starting capital. In fact, putting aside as little as £180 each month can be sufficient in the long run. Here’s how.
Building income
Most retirement planners advise to follow the 4% rule. This means that investors should aim to withdraw no more than 4% of their portfolio when retirement comes along. That way, the remaining capital can continue to grow, extending a portfolio’s longevity even when extracting money each year.
Coincidently, this also happens to be the average dividend yield of the FTSE 100. Therefore, assuming the index continues to offer this payout in the future, investors can follow the golden 4% rule by just taking dividends and not selling off any shares.
According to research group Finder, the median household savings rate is approximately £180 a month. So if families were to put this capital to work in the stock market, what sort of return can they expect to earn?
Looking again at the FTSE 100, the UK’s flagship index has generated an average annual gain of around 8% since its inception. Assuming these gains continue, consistently buying shares in a low-cost index fund would yield a portfolio worth just under £270,000 in 30 years. And following the 4% rule, that translates into a passive income of roughly £10,800.
Boosting gains with individual stocks
For many individuals, an index fund could be the best approach. After all, a lot of the investing process is automated. And some decent returns can be achieved without dedicating time to investment research and portfolio management.
However, it’s essential to realise that historical average returns aren’t necessarily going to repeat themselves. Unpredicted crashes or corrections could steer a portfolio off course. And even if the average gains drop by just 1%, that’s enough to wipe out £50,000 from a portfolio’s expected value over three decades.
Fortunately, stock picking provides a solution. By carefully buying high-quality enterprises at bargain prices, investors can potentially achieve returns greater than the historical market average.
In fact, this is precisely how Warren Buffett became a billionaire. And while replicating his success would be exceptionally difficult, I’ve already demonstrated how much of an impact a mere 1% difference can have.
Of course, with higher potential returns comes more risk. Building and maintaining a custom portfolio can be a complicated process that requires constant attention. And if managed poorly, it’s possible to end up underperforming the market, or perhaps even destroying wealth rather than creating it.
Personally, I feel that the challenges introduced by stock picking are worth taking on. But at the end of the day, investors should always pick the strategy that works best for them.
