For a lot of people, passive income is a form of pocket money. But with the right approach, I think it can be a lot more than that. In fact, simply by investing £10 a day in dividend shares I think it is possible to retire as a passive income millionaire.
It will certainly take time and I know that I might not get there. But starting in my mid to late 20s, I see the millionaire target as possible by standard retirement age. Here is how I would aim to do it.
Dividend shares as passive income ideas
First I think it is important to understand the source of the passive income I would be targeting – dividend shares.
Some companies distribute profits to shareholders as dividends. These are not guaranteed. But if they are paid regularly, they can start adding up. No one knows what a company will do in future when it comes to dividends. So, to reduce my risk, I would diversify my passive income-focused pot across different companies and business areas.
The power of compounding
In the short term, dividends can be a useful source of passive income. But if they are instead reinvested, over the long term they can be the basis of a sizeable fortune. That is because of what is known as compounding. Basically, over time if my reinvested dividends are generating still more dividends, the combined effect should get bigger each year.
For example, if I put £10 a day aside and invest it in dividend shares with an average yield of 8%, after 20 years I should hopefully have around £178,000. But, after another 20 years still contributing £10 a day, my pot will have grown to over a million pounds. None of this is guaranteed if course. But the potentially dramatic increase in value in the second 20-year period is despite me contributing only a steady £10 a day. That shows the power of compounding at work. The reinvested dividends would themselves be earning me more dividends.
Forty years may seem a long time. But if putting aside £10 a day for that length of time can make me a millionaire, I think it is worth doing.
Finding dividend shares
As well as time and the size of my contribution, another crucial element of my calculation is the use of dividend shares yielding 8%. If I invested in shares yielding 7% on average, after 40 years my investments would be worth ‘only’ £794,000. Due to the power of compounding, just a 1% difference in dividend yield can make a huge difference to my returns in the long run.
There are FTSE 100 shares that currently yield 8% or more, such as Rio Tinto and M&G. But I am targeting an average 8% yield for 40 years, not just right now. So to hit my target, I will need to take time to evaluate which dividend shares I could buy that hopefully might sustain an 8% yield or better for four decades. Such shares are few and far between.
Incidentally, in my calculation the increase in value is all due to dividends. I have not accounted for shifts in the prices of shares I own. If they fall, it may take me longer to become a millionaire. On the other hand, if the share prices increase, I may be able to retire a millionaire without even having to wait 40 years!
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Christopher Ruane 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.
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