There are multiple ways that investors can try to make an excellent passive income. Buying property and putting money into savings accounts are two traditionally popular methods. Peer-to-peer lending is also growing rapidly among those seeking a second income.
I think building a portfolio of UK shares is the best way to create a supplementary income stream, however. This method doesn’t require huge upfront costs like property investment. I am also likely to make a better return than I would from a simple savings account.
History is not always a reliable guide of what to expect. But with the right strategy, I could make an average annual return of up to 9.3% by buying British stocks.
This in turn could provide me with a healthy passive income for retirement. If things go to plan, a £9,000 lump sum investment in UK stocks today could eventually provide a £1,220 monthly passive income.
Here’s how I’d aim to achieve this.
Minimise costs
My initial step would be to open a tax-efficient financial product to hold my shares. In the UK, we are talking about either an Individual Savings Account (ISA) or a Self-Invested Personal Pension (SIPP).
The £20,000 annual allowance on an ISA is enough for most people. For those that can afford to invest more, the SIPP has an allowance of £60,000, although this is dependent upon what a person earns.
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.
I’d also carefully consider the management and trading charges I could expect to pay, which can differ greatly among providers. Some companies offer lower service costs and higher dealing fees, while others operate the other way around.
Reducing tax and minimising trading costs can, over time, have a significant impact on an investor’s eventual returns.
A 9.3% return
With my account up and running, I’d aim to create a portfolio dominated by FTSE 100 and FTSE 250 shares.
This is because the average annual return spread across these indexes is an impressive 9.3%. If this trend were to continue, a £9,000 lump sum investment right now would — after 40 years — transform into £366,092.
That’s equivalent to a £1,220 monthly income, assuming I drew down 4% of this amount each year.
A 4% drawdown would likely give me a 30-year sustainable income before the well ran dry.
A top value share
So what sort of stocks would I buy? Targeting value shares could be a good idea to build long-term wealth.
This is because shares that trade cheaply have the potential for significant price gains as their true value is recognised. They could therefore boost my chances of hitting that 9.3% average return, or even exceed it.
Vodafone Group (LSE:VOD) is a FTSE 100 value share I think could deliver spectacular returns. It trades on a forward price-to-earnings (P/E) ratio of 9.2 times.
It also has a price-to-book (P/B) ratio of 0.4. A figure below one indicates that Vodafone trades at a discount to the value of its assets.
While it faces strong competition, I believe Vodafone shares could still deliver phenomenal returns as increasing digitalisation drives telecoms demand. Its extensive African operations may also help it achieve excellent profits as wealth levels there rapidly rise.
I believe a portfolio filled with value stocks like this may eventually deliver a healthy passive income.
