Making a passive income that covers 100% of an annual wage is likely to be a long-term goal for many people. After all, this would mean they no longer need employment to obtain the same level of financial freedom enjoyed while working.
Although many UK shares have fallen in value over the past year, they offer a sound means of obtaining a nest egg from which an income can be drawn. With many of them currently trading at cheap prices following the 2020 stock market crash, now could be the right time to start buying them.
Building a portfolio to make a passive income
With the median UK salary currently around £31,000, a passive income of a similar figure is likely to provide many people with financial freedom. Assuming they build a nest egg during their lifetime, they would need a lump sum of around £775,000.
This is based on the assumption that they withdraw 4% of their capital each year. This has historically been a common amount to withdraw, since it can mean a nest egg retains its value on an after-inflation basis over the long run.
Clearly, achieving a £775,000 nest egg sounds like an extremely challenging task at first glance. However, the track record of the stock market shows it may be far more achievable than many realise. For example, the FTSE 100 has delivered an annual total return of 8% since its inception in 1984.
Assuming that same percentage return on a £500 monthly investment, it would lead to a portfolio valued at £775,000. And that would provide a £31,000 annual passive income in just over 30 years.
Buying cheap UK shares today
Of course, the above example assumes an investor obtains the same annual return as the stock market. However, there are currently many cheap UK shares available to buy that could deliver even higher returns. Not to mention a more attractive passive income. Buying them today could be a sound move, since they appear to offer scope for above-average capital gains in many cases.
For example, many high-quality companies are trading at prices that may undervalue their prospects. That’s down to short-term uncertainty caused by political instability or coronavirus. Given their financial strength and market positions, they’re likely to overcome such threats to produce sound share price recoveries over the long run.
The result could be a larger portfolio than one which tracks the performance of the FTSE 100. As well as a larger passive income in older age.
Understanding risks
Clearly, it’s important to diversify when building a portfolio and making a passive income. Holding a variety of stocks may lead to higher returns with less risks. This may improve an investor’s capacity to fully replace their hard-earned wage, and enjoy financial freedom in the long run.