There are many approaches investors can use to build a passive income. Buy-to-let real estate is often a go-to strategy, as is starting a small business. Yet, in my opinion, these solutions pale in comparison to investing in the stock market.
Owning dividend shares comes with its own set of headaches. But they’re significantly less hassle- and capital-intensive than the previously mentioned alternatives. After all, a successful income portfolio can be kicked off with just a few hundred quid each month. And it doesn’t require an individual to saddle themselves with a giant pile of debt.
That’s why someone who’s just started building their savings may want to consider investing instead. There’s no denying it comes with more risk. But in the long run, it’s possible to turn £500 of a monthly paycheck into a £69,800 annual passive income. Here’s how.
Earning a five-figure second salary
With low-cost index funds now prevalent, it’s never been easier to start putting money into the stock market, even with next-to-no knowledge. These funds mimic the construction of a benchmark index like the FTSE 100 and replicate their performance.
This approach comes with a lot of advantages. A portfolio can become instantly diversified, rebalancing is all automated, and investors don’t have to spend countless hours researching companies. Historically, the UK’s flagship index has delivered gains of around 8% a year, half of which stems from reinvestment of dividends.
Assuming the FTSE 100 will continue to deliver these gains over the next 40 years, investing £500 each month at this rate would translate into a portfolio worth a whopping £1.75m! And taking the 4% dividend as an income translates into a salary of £69,800. Moreover, doing all of this inside a Stocks and Shares ISA also means all this wealth is completely tax-free.
Maximising returns
For many, index investing is likely the most suitable option. However, for investors looking for even bigger returns and are comfortable with taking on more risk, picking individual stocks could be a worthwhile pursuit.
Building a custom-tailored portfolio is far more demanding. Even if an investor is an expert in researching and analysing stocks, portfolio management can be a beast in itself. Having improper asset allocation can still lead to disappointing results. Not to mention the higher level of volatility an investor can find themselves exposed to.
But despite all these caveats, stock picking is how investors like Warren Buffett achieved market-beating returns. And even if an investor manages to only achieve an extra 2% in annualised gains over 40 years of compounding, that translates into a pension pot worth almost double at £3.16m and an annual passive income of £126,480!
Nothing is risk-free
As exciting as these prospects sound, it’s critical to consider risk. Even when using an index investing strategy, a portfolio can be taken for a spin. Forty years is plenty of time for multiple crashes and corrections to emerge. And depending on the timing of these events, investors may end up with considerably less than expected.
As for stock pickers, a poorly constructed portfolio could end up lagging the market. Perhaps even destroying wealth rather than creating it. Risk management is critical to success along an investment journey. But by keeping risk in check, it’s possible to achieve financial freedom in the long run.
