How I plan to create a passive income for retirement

Even though the government is keen to keep increasing the State Pension (it will rise 3.9% from 6 April), you’d still be better off if you could create an independent passive income for retirement. In my view, the State Pension won’t provide a comfortable retirement, putting the onus on an investor to have their own additional income when they stop working. 

Long-term focus

So where do you start? Unless you’re approaching retirement in the next few years, having a long-term view is going to be a key consideration.

One of the many advantages of adopting a long-term mindset is it allows you to see beyond what are hopefully short-term problems such as the coronavirus. In 10 years’ time, will the coronavirus still be hitting company profits? Almost certainly not. And if it is, there’ll be bigger problems than the stock market to worry about.

Another advantage of a long-term view is it allows you to invest when stock markets dip – as is happening now – without panicking about where they’ll be in one, three or six months’ time. Instead, you can focus on where the stock market will be in five or more years. This perspective makes it easier to make rational decisions.

Careful diversification

There’s a balance to be struck when it comes to diversifying an investment portfolio. On the one hand, diversification reduces risk. If you don’t have a lot of experience or understanding of the stock market, it’s certainly the safer option. But many top investors warn against over-diversification. Warren Buffett is a classic example. He argues for those who know what they’re doing, being overly diversified limits gains and decreases your knowledge of specific stocks and sectors. 

Fund managers such as Nick Train, who runs the Lindsell Train investment funds, likewise tends to invest in fewer shares than most other professional fund managers. His returns are often much better.

This is because having a concentrated portfolio allows each company to contribute more to the performance of the portfolio, rather than acting like an index tracker. It has the added benefit that trading costs are likely to be lower as you buy and sell fewer shares. It doesn’t mean you should just buy one or two shares, but you don’t need 40 different shares in your portfolio either!

Focus on dividends and reinvesting

The third aspect worth focusing on is the wealth-enhancing power of dividends. By investing in dividend-paying companies, you as an investor receive an income from profits. Over time, this income can be used to buy more shares and this reinvesting becomes a virtuous circle. 

How so? You receive more dividends, you buy more shares and those additional shares provide more income. Year-on-year you benefit from what’s known as compounding. This helps a shares portfolio grow fast.

These are three steps in my plan to save and invest my way to a richer more fulfilling retirement. Sometimes the best plans aren’t complicated. The tricky part is having the patience and perseverance to make it happen. If you can make it happen though, and live off a passive income in retirement, you’ll realise it’s definitely worth it.