One of the most common financial goals among investors is to earn a second income. After all, who doesn’t love the idea of watching the money roll in without having to work for it? And the increased financial freedom can even open the door to earlier retirement, allowing for more time to be spent having fun with family and friends.
However, achieving this milestone can be a bit daunting, especially for beginner investors. So if I were starting from scratch with a brand new Stocks and Shares ISA, here’s how I’d aim to earn a £50,000 second income in the long run.
Calculating portfolio targets
Using the FTSE 100 as a proxy for the UK stock market, we can see that historically, investors can expect to earn a dividend yield of around 4% a year. By being a bit more selective instead of relying on index funds, this portfolio yield can realistically be increased to 5%, or perhaps 6%, without taking on too much extra risk.
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But even at the higher payout rate, if I’m aiming to earn a £50,000 second income each year, that means I need a portfolio worth just over £830,000. So now the question becomes, how do I reach this milestone?
As daunting as this objective seems on paper, it’s actually far more achievable than most would think. In fact, investing just £500 a month could be all that it takes.
Let’s assume the FTSE 100 will continue to deliver its long-term historical return of 8% a year. At this rate, investing £500 each month into an index tracking portfolio would reach the £830k threshold in just under 32 years. For successful stock pickers who earn an extra 2% each year, the timeline’s shortened by roughly five years.
While both scenarios require a fair amount of patience, it demonstrates that building a near-£1m passive income portfolio isn’t as impossible as many people believe.
Risks of investing in high-yield stocks
It’s important to highlight that the previous example isn’t a guarantee. Returns generated by the FTSE 100 over the next 30 years could be slower than expected. And the same is true for a custom-built portfolio, which could even underperform the benchmark index if low-quality stocks are bought.
The risk for stock pickers is driven even higher when venturing into high-yield territory. Take British American Tobacco (LSE:BATS) as an example. The tobacco business is one of few Dividend Aristocrats that has consistently hiked shareholder payouts for decades. And right now, buying shares would lock in an impressive dividend yield of 8.7%.
Despite efforts to reduce the popularity of smoking, the firm’s customers are seemingly willing to continue paying higher and higher amounts for tobacco and cigarettes. Subsequently, British American has proven itself to be a highly cash-generative business that’s enabled dividends to keep on rising.
That certainly makes the yield look quite enticing right now. Unfortunately, pressure on tobacco companies is rising. Management has acknowledged this threat with significant investments being made into healthier cigarette-alternative products like vaping devices.
Sadly, despite a strong start, performance in this space has started to slow as competition intensifies. And it’s unclear if management can replicate its tobacco industry-leading status in this space before regulations on cigarettes clamp down even harder by governments around the world.
