John writes in:
You’ve mentioned before how a person might slowly build up income-earning investments to provide an income stream for them. How would that actually work? Let’s say I can squeeze out $100 a month for this. What would I do?
Okay, let’s do this.
First of all, you need to have selected something you’re going to invest in. You’re going to want something that gives you a direct return of some kind on a regular basis. That can be an index fund, a particular type of bond, a treasury note, or a dividend-paying stock, among other things. Each have their own particular risks and rewards that you’d want to study if you were making such a decision, but generally, investing in a company you know really well, in a very broad selection of companies (as in an index fund), or in the federal government are all good way to go.
Let’s say, for the purposes of this example, that you’re investing in Coca-Cola. Here’s the dividend history of Coca-Cola – for this example, we’ll say that Coca-Cola maintains a quarterly dividend of $0.26 for the foreseeable future. Also, here’s the stock price for Coca-Cola. We’ll say that their price per share holds steady at 38.91. I’m going to round a few numbers here and there and simplify a bit just to keep things clear.
The first thing you’d want to do is start saving that $100 per month. You would not want to buy each month, because with most brokerages you’d have to pay a fee for each purchase you made. Instead, I would recommend saving for a year and making one single purchase each year.
So, you save up $1,200. You open an account with some brokerage and spend that $1,200 on shares of Coca-Cola stock, of which you can afford 30 shares (we’ll stick with even share numbers). If your fee for buying is $9.95, that leaves you $22.65 for next time.
So, you now own 30 shares of Coca-Cola. Four times during the year, each share pays a dividend of $0.26. That’s a return of $31.20 over the course of that year.
Until you actually need the income, it’s usually wise to reinvest it. So, you take the $1,200 you saved in year two, the $22.65 you had left over from year one, and the $31.20 you earned in dividends from year one, and you use it to buy 32 more shares of Coca-Cola (with a $9.95 fee), leaving you $1.22 left over.
During the second year, you own 62 shares of Coca-Cola. The company pays a quarterly dividend of $0.26 per share, earning you $64.48 in dividends over the course of the year.
So, you reinvest again, buying 32 more shares (with your $100 a month savings and the dividends from the previous year) and leaving you with $1.90 left over. You now own 94 shares of Coca-Cola, which earns you $97.76 in dividends over the course of a year.
After the third year, you’re earning back almost $100 a year in dividends, and this will only accelerate from there.
There’s also the fact that your investment itself will retain value (and possibly gain it). You own shares of Coca-Cola, which are things you can sell if you so choose to recoup your investment. Of course, Coca-Cola shares may have gone up in value or they may have gone down in value, so you might earn more than you invested when you sell or you might earn less.
The truth is, though, that no investment will quickly recoup your income if you dump only $100 a month into it. At that rate with this investment, the dividends wouldn’t reach the $20,000 per year mark for about 250 years. In order to hit the kinds of numbers you’d need for an investment’s return to start replacing your income, you need to look at putting amounts on the order of $250 per week or $1,000 per month into this type of investment.