Image source: Getty Images
Generating passive income from stocks is not too difficult at first. But reaching the impressive sum of £50,000 in annual passive income will take time and patience. This is why a SIPP (Self-Invested Personal Pension) is arguably the ideal vehicle to achieve this long-term goal.
This is because unless I’m 55 (or 57 from 2028), I can’t tap into my SIPP and sell shares to raise cash. And this helps us follow investor Charlie Munger’s first rule of compounding: never interrupt it unnecessarily.
Here are three easy steps you would take to reach £50,000 in annual passive income.
Invest like clockwork
The best way to grow my wealth in a SIPP is to make regular investments. I’m a stock market investor, so the vast majority of my DIY pension is invested in shares of different companies. And I’m more or less evenly split between US and UK listed stocks.
The reason I invest in stocks is because of the numbers. They have outperformed all other asset classes (bonds, cash, etc.) over the very long term.
Now, that doesn’t mean that investing in the stock market is necessarily easier. Quite the opposite, in fact. The market can be extremely volatile at times, and stock prices fluctuate in surprising ways. Some companies may even go bankrupt (Cineworld is a recent example of this).
However, for many decades, UK and US stocks combined have managed to generate an average annual return of 7% to 10%. Stock markets are therefore battle-hardened, having shrugged off numerous wars, recessions, financial crises and, now, a serious global pandemic.
Of course, none of this guarantees that stocks will perform the same over the next two decades. But in the grand theater of wealth creation, I think stocks will continue to take center stage.
Quality at a reasonable price
Rather than filling my SIPP with speculative bets, I would favor high-quality companies that have durable business models and sustainable competitive advantages.
An example would be ferrari (NYSE: RACE), which is arguably the most powerful luxury brand in the world. Their clients are the super-rich, so they are largely insulated from cost-of-living pressures. And the firm maintains an aura of exclusivity by always manufacturing one car less than what the market demands. This gives it almost unlimited pricing power and large profit margins.
However, identifying great companies is only part of the investment. The other is to evaluate whether the stock of a company I like is trading at what I consider a reasonable valuation.
In Ferrari’s case, the stock is currently trading at a P/E ratio of 49. This is a premium valuation that could present risk if markets head lower or if the company’s growth suddenly slows. However, in the long term I am optimistic.
Passive dividend income
So let’s say I invest £100 a week for 30 years into my SIPP. How much could I end up with? Well, assuming you achieve an average annual return of 8.5% (at the midpoint of the historical average), you’d end up with around £837,818.
If I then changed my focus to dividend paying stocks that yield 6% per annum, then I would expect to generate just over £50,000 in passive income annually.
Better still, as things stand, I can claim tax relief on my SIPP contributions. Investing that extra money would significantly increase my final amount.
