Earning a second income is a common financial goal. After all, having extra money in the bank paves the way to a more comfortable lifestyle as well as the potential for an earlier retirement. What’s more, by using a tax-efficient wrapper like an ISA, all this extra money can keep flowing without the taxman interrupting the process.
Using an interest-bearing Cash ISA is a relatively low-risk option. However, leveraging the power of a Stocks and Shares ISA could yield significantly better results in the long run. And it could even open the door to earning £45,210 each year!
Potential long-term income
The first steps of an investing journey can be quite daunting. Learning the basic mechanics of the stock market is simple enough. However, understanding how to navigate volatility can be quite a challenge when wealth is on the line. That’s why a good place to start for most beginners is with index funds.
These investment vehicles are designed to replicate an underlying index such as the FTSE 100. They provide instant diversification and put portfolio management on autopilot. As such, the level of effort required is minimal while reaping annual returns of around 8%. At least, that’s what the last 30 years have shown.
Investing £500 a month at this rate for three decades translates into a portfolio worth £745,180. And by following the 4% withdrawal rule, that translates into a second income of £29,807. That’s certainly nothing to scoff at. But by taking a more hands on approach with stock picking, these figures can climb significantly.
Building a custom portfolio opens the door to potentially market-beating returns. And even a few extra percentage points can make a world of difference when compounded over 30 years. For example, if the same portfolio had achieved a 10% return each year, its value would stand at £1.13m. That translates into a passive income of £45,210.
Investing has its risks
As wonderful as growing wealth by 10% each year sounds, it’s important to realise that this goal is far from guaranteed. Picking individual stocks is far less forgiving compared to passive index investing strategies. And a series of bad decisions could result in the destruction of wealth rather than its creation.
Let’s take a look at Vodafone (LSE:VOD) as an example. Shares of the telecommunication giant have been on a pretty dire trajectory, falling by 50% over the last five years.
The company has made impressive strides with its M-PESA mobile money service. The fintech solution is now used by more than 51 million people across Africa, resulting in a lot of hype among investors. After all, Vodafone has just succeeded in a market where other industry giants have failed.
However, this success has been ultimately dragged into the gutter by the lack of progress with the rest of the company. More specifically, it’s debt. Through a combination of mismanagement and complacency, Vodafone has racked up €57bn of loans on its balance sheet. That’s almost triple its market capitalisation.
This extreme level of gearing isn’t a new problem. It’s one that’s developed over many years that prudent investors noticed long before interest rates were getting hiked. And it goes to show that by analysing a firm’s financial and operational position instead of getting lost in the hype, traps can be avoided.
This post was originally published on Motley Fool
