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It’s a myth that you need a huge amount of money to earn meaningful passive income. By putting aside £100 a month, I think it’s possible to make £1,000 a year in less than 10 years.
Don’t get me wrong – having a big sum to invest is helpful. But it’s not necessary for investors who are able to be patient and consistent over a long period.
The secret sauce
There’s one thing long-term investors need to focus on more than anything — the power of compounding returns over a long timeframe.
If you invest £100 at a 5% rate of return, it earns you £5 in year one. But if you reinvest that cash at the same rate – and do this every year – you get £13.20 in year 20, and £21.75 in year 30.
That £100 gradually earns more and more income on its 30-year journey. So now imagine what happens if you start a new £100 off on a new journey each month for 30 years.
The end result is a portfolio of £100 investments that generate a total of over £4,000 a year in passive income. And the exciting thing is, investors might even aim to do better than this.
FTSE 100 returns
Over the last 20 years, the FTSE 100 has returned an average of just over 6.5% a year. And at that rate, a £100 monthly investment returns £1,000 within 10 years.
Now, the fact the index has returned this in the past doesn’t mean it’s going to again. Future returns might be higher or lower than the historic average.
I think though, investors can give themselves the best chance by doing two things: focusing on quality names and building a diversified portfolio over time.
One of the nice things about the UK stock market is that it attracts less attention than the S&P 500. And that makes it easier to find opportunities in shares trading at attractive valuations.
A potential starter
A really interesting stock to consider starting a portfolio with is Diploma (LSE:DPLM). The industrial distribution business isn’t exactly a household name, but it’s a strong business.
The company’s structure make it an interesting idea for someone starting out. It’s made up of several smaller businesses that operate independently of one another.
This offers some instant diversification – buying one stock involves investing in a number of businesses. And part of Diploma’s growth strategy involves adding to these over time.
There isn’t a 6.5% return on offer from the stock right now. But the firm‘s tripled its sales in the last five years and if it continues, I think it could average this over the next decade.
Risks and rewards
I think Diploma’s one of the FTSE 100’s highest-quality names and its growth prospects are second-to-none. But no investment’s guaranteed to succeed.
With a strategy driven by acquisitions there’s always a danger of overpaying. Even billionaire investor Warren Buffett’s been known to do this from time to time, so investors can’t rule it out.
In my view, the best way to try and limit this risk is by building a diversified stock portfolio over time. This means if something does go wrong, the overall effect’s limited.
