Passive income? No, I’m relentlessly compounding equity

Our writer thinks wanting to earn passive income is tempting. Yet, he thinks the wiser approach is building up equity over time. Let’s see why.

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I think dividends or bond payments for passive income are suitable for retirement. But I’m young and seeking to build up assets for the generations after me.

If I were to spend dividend payments now or focus on investments solely for passive income rather than share price increases, I feel I’d be giving up real wealth for the sake of spending today. I’d rather sacrifice the present for the future, which is what investing is all about to me.  

Don’t get me wrong; dividends, bonds, and rental income are prominent in effective asset management. It’s just not my strategy. Here are the main reasons why.

I think equity wins

The great thing about choosing companies to invest in for the growth and value of their shares is that sometimes they also pay dividends.

For example, Apple has a dividend yield of around 0.5%. I know that’s not up there with the highest dividend yields of about 8%, but this is Apple, with an average 27% annual return over the past 10 years.

Investing £10,000 in Apple 10 years ago would have garnered £145,000!

One challenge when it comes to investing solely in the stock market and not considering bonds, dividends, or real estate is that I think stocks are usually more volatile. That means share prices can rise and fall a lot.

Luckily, I’ve got the strong stomach and the patience to hold great companies through corrections, crashes, and even depressions.

I reinvest dividends

I don’t want to sit on idle cash, and I don’t want to spend it.

I’m a big advocate of working for money and want to add value to the economy.

It’s my paycheques I use to finance my life. Hopefully, the capital I build up will help me invest in companies that I think are doing good for the world. So, I reinvest my dividends to build up more of a foundation to do this.

I think no one got wealthy by spending

Even when buying something like a real estate investment trust (REIT) by Vanguard, I’d only be getting a yield of around 4.5%. Now let’s say I spent that to live on. First, I’d need at least £1m invested for just £45k in yearly income pre-tax. Of course, I’m aware that these yields are not guaranteed.

So, what if I invested a more realistic £50k in that REIT? That would give me £2,250 a year, which is nowhere near enough to live on.

Now, what if I took that £2,250 and invested it into an S&P 500 exchange-traded fund? That has an all-time average annual return of around 10% and a dividend yield of about 1.4%. However, past returns are not indicative of future results.

Ten years later, I’d be sitting on an extra £45k in equity if I reinvested all my dividends. I’d also have to reinvest my yearly £2,250 real estate yield into the S&P 500 to get that figure.

Of course, unforeseen events like a pandemic or war could seriously deplete my investment returns. However, dividends and rental yields are also often affected by such circumstances.

The top lesson I keep telling myself is not to spend my dividends and to continue to invest consistently. That way, I think wealth isn’t an impossibility; it’s a reality that takes time.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Oliver Rodzianko has positions in Apple. The Motley Fool UK has recommended Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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