My first try at passive income failed miserably. I optimistically put a few thousand pounds in the premier savings account of a ‘big 4’ bank. After a month, I got back 40p.
As irritating as investing at near-zero interest rates was, I learned from the experience. And since then, I’ve discovered better ways to multiply the cash I save from the day job.
Let’s say I was starting again today with a £20k Stocks and Shares ISA. Here’s how I’d swerve the years of mistakes and target £13,959 of passive income a year.
Opening the ISA itself would be the first hurdle to clear. Investing in stocks would have sounded crazy to me at a younger age. I pictured the stock market as loud trading floors and people dressed like Gordon Gekko – not something I saw myself getting involved with.
Investing timeline
What changed my mind was comparing the returns to other asset classes. Whether it’s gold, property, savings accounts, or anything else, for smaller investors, the stock market is the best place to make money.
Take a savings account. I could get a guaranteed 5% at the moment. Sounds pretty good? Well, no, I don’t think so. I’ll explain why by looking at how my £20k in a Cash ISA would grow over a 30-year investing timeline.
5%
Start
£20,000
5 years
£25,526
10 years
£32,578
20 years
£53,066
30 years
£86,439
Okay, that’s a decent baseline. I’ve made some money. I could even withdraw a small passive income from it too. So what about a Stocks and Shares ISA then?
Well, stocks are more volatile. I couldn’t rely on a regular cash return each year. On average though, a target of 10% is in line with historical averages. Let’s use that for this example.
10%
Start
£20,000
5 years
£32,210
10 years
£51,875
20 years
£134,550
30 years
£348,989
Right, what’s going on here? My 5% return gives me £86k and my 10% return gives me £349k. Doubling the rate of return should double the final cash amount, shouldn’t it? Well, no, it actually gives back a lot more cash than anyone might expect.
It sounds strange at first, but this is simply the unique effect of compound interest. I make much more money because I’m getting ‘interest on the interest’. Even a few percent extra balloons the size of the nest egg.
Grow wealth
Of course, there are risks here. I’m basing my potential earnings by looking at the past. Historical stock market returns were lucrative. But the future? No one has a crystal ball.
Also, I wouldn’t withdraw 10% as income. I’d use the 4% rule for withdrawals to ease the impact of volatility. The above example would hand me passive income of £13,959 a year.
I only compared savings accounts and stocks here, but the calculation rings similarly true for other investments — at least the ones those of us on average salaries have access to.
The post I’d aim to turn a £20k ISA into passive income of £13,959 a year appeared first on The Motley Fool UK.
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John Fieldsend has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.
