I’m a big fan of the financial independence, retire early (FIRE) movement. The idea of building a sustainable passive income to supplement and hopefully replace my nine-to-five gig sounds ideal.
Of course, there is a lot of hard work, discipline, and good luck needed to achieve another earnings stream. I think investing in high-quality UK stocks is one of the most achievable ways for me to do this.
Here are three things that investors should be considering when building a passive income for the future.
Investing in the right stocks
Picking the right investments is key. Personally, I prefer stocks with high dividend yields as payout levels tend to be relatively ‘sticky’. Company boards tend to avoid reducing dividends substantially, when they can, to avoid sending the wrong signal to investors.
There are many high-yield stocks on the Footsie. One example is Legal & General (LSE: LGEN), which is currently yielding an impressive 8.7%.
That is well above the Footsie average of around 3.5% and one of the highest within the UK large-cap index. The company is a major player in the UK asset management industry and could benefit from pension consolidations as it seeks to grow assets under management and associated fees.
While high yielding, Legal & General isn’t one for me at the moment. The company’s dividend coverage ratio of 0.9 indicates its earnings aren’t covering its dividends and that creates question marks over future payouts. The price-to-earnings (P/E) ratio being north of 40 is another concern for me.
To that end, it’s important to be aware of the dividend value trap. This happens when investors buy a stock for its high yield but in reality the share price is falling due to poor performance, making the yield look artificially high.
While I’m all for dividend payers that can boost my future portfolio value, Legal & General isn’t one for me. There are several other Footsie stocks with strong yields including GSK, which I am considering.
Building sustainable savings habits
Investing in the likes of Legal & General and other dividend stocks is only possible with cash to invest. Investors that can build healthy savings habits for the long run are really in the box seat to build a sizeable passive income.
These habits are also helpful when hunting for bargains. Investors that have the cash available to buy when others are selling could potentially invest in some cheap stocks and propel their returns in the long run.
Having a rainy day fund
The above is all well and good, but investors can be easily caught out by market movements. The stock market tends to be cyclical, so a recession could impact the value of a portfolio at the same time as people need the cash most.
Clearly, it’s best to avoid selling at the bottom. One of the best ways for investors to protect themselves is by building a ‘rainy day’ or emergency fund to cover a reasonable amount of expenses.
That amount will vary for everyone, but I tend to keep three to six months’ worth of expenses tucked away. By doing this, while picking the right investments and steady savings habits, I can hopefully avoid forced selling and build a long-term passive income.
The post 3 things investors should consider when building a £10k passive income appeared first on The Motley Fool UK.
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Ken Hall has no position in any of the shares mentioned. The Motley Fool UK has recommended GSK. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
