Passive income should be the goal for every wise investor. And getting a regular income from stocks and shares is simpler than it might seem.
The way that the world’s best investors do it is to focus on dividend income.
Think of Warren Buffett. He has rigorously applied the same strategy for 60 years and there are some key elements that have remained the same throughout the decades.
Following his path could help build passive income for a seriously impressive nest egg.
How to start building passive income
To begin with I’d open a Stocks and Shares ISA. The tax benefits are immense.
In a Stocks and Shares ISA, investors pay no tax on the dividends they receive. This is a crucial point for building passive income.
If instead I decide to invest in FTSE 100 or FTSE 250 shares outside of an ISA? The maximum I can receive in dividends every year before paying tax is just £2,000. This is a vast reduction from 2018, when the upper limit was £5,000 per year.
So today’s investors are much worse off than those that came before them. Doesn’t seem very fair, does it?
Fortunately, as an added benefit, investors pay zero tax in a Stocks and Shares ISA if the value of their shares rises. This is called ‘capital gains’. That means it’s much easier to build passive income by using such an ISA than by ignoring it.
Pound-cost averaging
Let’s talk about one of the key rules that Warren Buffett has followed in building a multi-billion-pound empire. He says that passive income is simpler to achieve if you invest the same amount every month. Warren Buffett calls this ‘dollar-cost averaging’. For our purposes as UK investors we can think of this as ‘pound-cost averaging’.
Buffett’s theory has been proven to work over six decades of investing. It says that I will get better results overall if I build positions in shares consistently, both when their prices are a little higher and when they are a little lower.
Many UK Stocks and Shares ISAs will actually offer cheaper prices to buy shares if I set up a direct debit for the same amount every month.
For example, Hargreaves Lansdown runs one of UK’s most popular Stocks and Shares ISAs. In its version, there is a special feature called ‘Regular Investing’. This condition is only unlocked if I invest every month.
Passive income growth
Within this, I could choose to build passive income by investing in popular funds like the FTSE 100-listed Scottish Mortgage Investment Trust that owns stakes in big names Amazon and Tesla. I can also focus on FTSE 100 dividend shares with the largest payouts, like British American Tobacco at 8.3%.
With regular investing, the amount I have to pay in a Hargreaves Lansdown Stocks and Shares ISA to buy the shares drops from £11.95 per trade to just £1.50 per trade. That’s a whopping 87% less that I have to pay in fees. Other Stocks and Shares ISA providers are available, of course. Some of the most popular UK ones are AJ Bell and Interactive Investor.
When we zoom out and take a big picture investing view, these little things can add up to massive passive income benefits.