Passive income is pretty handy to have. It’s some extra money in my pocket from very little additional work. I’d say the key to creating it is good planning plus ample time. The longer I can invest for, the greater I hope my passive income will become.
Building a passive income
Let’s take a look at an example. If I were to invest just £25 a week in a basket of shares, that means £1,300 every year. As it happens, I’d quite like £1,300 to spend on a holiday every year. By my calculations, I’d just need to invest £25 a week for a decade before I could start withdrawing £1,300 annually in dividends.
Here’s how I’d do it. I’d drip-feed £25 every week into my Stocks and Shares ISA. This tax wrapper will save me from capital gains tax and dividend tax, so it’s a ‘no-brainer’ for me to use it. I’d start by setting up a monthly programme to purchase a basket of quality shares. This could be individual shares, a managed fund or an index fund. Picking individual shares could require some extra reading and potentially could be a higher-risk, higher-reward option. Investors have varying degrees of risk-appetite. I’d say I have a moderate attitude to risk, given I have a decade-long time frame.
My top picks right now that I would buy and hold for a decade include Diageo, Persimmon and Amazon. When looking at long-term shares, I’d say it’s important to look for solid, and stable companies that I think will not only survive but thrive. I’d want to find businesses that have mega trends that could work in their favour, like rising populations or the shift from physical retail to e-commerce.
A more hands-off approach could be to buy a managed fund or index fund. These are typically more diversified and could be a low-cost option for investments such as this.
Dividend income
After 10 years, by investing in these quality shares or funds, I calculate I should have an investment pot of roughly £20,000. This assumes I gain approximately 10% per year. Although this is a long-term average rate of return it’s by no means guaranteed. Future returns could be far lower. Next, I’d do some homework to find the best dividend shares at the time. The average FTSE 100 dividend yield is currently 3.4%, but with further research I reckon I could find some quality shares that pay 6%-7% instead. £20k invested at 6.5% per year would equate to £1,300 in annual income. However, bear in mind that dividend yields can fall too.
Currently, I’d look at quality dividend shares such as Rio Tinto, BHP Group and Jarvis Securities. But in 10 years, the best dividend-payers could well be different. It’s also important to note that I’d need to look at more than just the dividend yield. I’d like to find dividend-payers with a good track record of regular and growing dividends. Ideally, I’d also like to see a steadily growing business with rising earnings. Overall, I’d want a rising share price and an excellent dividend yield.
Bear in mind that I’ve assumed my initial investments will achieve the long-term average stock market return. But stocks and shares returns aren’t guaranteed, and there have historically been periods of underperformance. That could well happen for the next decade.