Passive income’s a terrific way to top up an existing income. Apart from having more money in the bank, it requires little effort to continue earning after it’s been established. That’s why it’s such a popular financial objective worldwide.
There are numerous methods to start earning some extra cash passively. However, my personal favourite is leveraging the power of compounding through dividend stocks. While it comes with its own set of risks, investing in the stock market requires far less capital than most would think.
In fact, just £3.40 a day – the price of a Tesco Clubcard Meal Deal – is enough to get the ball rolling.
Dividends vs interest
Income stocks are fairly straightforward. Typically, each will have a mature enterprise behind them whose days of high growth are in the rearview mirror. But while sales and profits may no longer be expanding by double digits, the cash flow could still be gushing. And if management has no better use for it, this money is distributed to shareholders via dividends, generating an income stream.
Looking at the FTSE 100 index, the UK’s largest enterprises are currently offering an average dividend yield of around 3.6%. That means for each £100 invested, investors are earning approximately £3.60. On the surface, that doesn’t sound all that enticing. After all, due to higher interest rates, there are savings accounts offering better rates at far less risk.
However, unlike savings accounts, dividends aren’t bound to the monetary policy set by central banks. As such, they can increase significantly over the long run. And a 3.6% yield today could be worth considerably more in the future. Not to mention that by picking individual income stocks, it’s possible to lock in much higher yields straight away.
How much can I earn with £3.40 a day?
By skipping out on a Tesco Meal Deal each day, a total of £1,241 is saved every year – or roughly £104 a month. This capital could be invested into a FTSE 100 index fund to start growing at around 8% a year. Or instead, investors could seek a potentially far greater return by picking individual stocks.
Take Safestore Holdings (LSE:SAFE) as an example. Over the last 10 years, the self-storage operator has generated a total return of around 500% – that’s an average of 19.6% a year! So for those who were putting aside £3.40 every day over this period, they’re now sitting on a portfolio worth around £38,130. And following the 4% withdrawal rule, that’s an extra £1,525 in the bank each year.
Keeping expectations in check
Safestore’s been one of the better-performing dividend shares of the last decade. But, unfortunately, there’s no guarantee its impressive track record will continue. This is especially true given that the group was a massive beneficiary of the near-zero interest rate environment.
Higher rates make the expansion of its self-storage network across the UK and Europe more costly. And as top-line growth slows, so will dividends and, in turn, shareholder gains. As such, investors may not be so fortunate to enjoy near-20% annual gains moving forward.
Nevertheless, it remains a rock-solid enterprise dominating the UK market, generating plenty of excess cash. And there are plenty of other passive income stocks yet to be discovered that can deliver Safestore-like returns by 2034.
This post was originally published on Motley Fool
