How To Create A Seven Figure Residual Income
January 1st, 2008
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Admit it, you think that headline is complete hype, don’t you? I can’t blame you. People who think they’re financial experts go on and on about how creating a six figure residual income is impossible, and anyone who says otherwise must be promoting a scam. When you see enough of this, you might start to believe it.
It’s a shame, though. Creating a six figure residual income is actually quite easy, if you have enough time to wait. So easy, in fact, that I decided to make the challenge a little tougher. I’m going to show you how to realistically create a seven figure residual income, without any smoke and mirrors.
If you have Microsoft Excel on your computer, you can open the spreadsheet stocks.xls. Otherwise, you can see the HTML version at the bottom of this post. Yes, we’re going to create our seven figure income with common stocks.
From 1928 to 2002, large cap stocks averaged a 10.8% annual return, and small cap stocks averaged a 12.5% annual return (source). We’re going to assume a 10% annual return for this example. You can think of our hypothetical portfolio as a mix of large caps and small caps, with taxes paid on distributions.
We’re going to assume that we’re starting at age 22, right out of college. I know you’re probably older, but you can change the age and other parameters later. We’re also going to assume that we have a job with an above average salary (like an engineer), and we’re willing to forgo some consumption today in order to invest for the future. This will let us invest $1,000 a month (for simplicity, we’ll assume a single investment of $12,000 is made each year, with the distributions reinvested). Now realistically, this is more than a 22 year old engineer can invest, but I think it’s a fair assumption because it won’t be too many years before they can invest much more than $1,000 a month.
Let’s take a look at our spreadsheet. We have one column showing our age. I’ve entered 22 for the age in the first row, and it automatically increments from there. Off to the right, we have two other parameters: our annual investment ($12,000), and our rate of return (10%).
The two other columns are Portfolio Value and Est. Annual “Income.” Portfolio Value refers to the amount we’ve accumulated over the years by investing $12,000 a year at a 10% rate of return. Est. Annual “Income” refers to the amount of residual income that’s generated annually from our portfolio. Our money gives us a 10% return just by sitting there.
The reason I put “Income” in quotes is because some people would argue that it’s not income. I agree that it’s not realized income, meaning money that is actually paid to us as cash in the form of dividends and capital gains distributions. Most of the gains are unrealized, meaning they’re sitting in our investment account instead of in our hands. It’s still real money though, and I think making a distinction is splitting hairs for the purpose of this example.
Returning to the spreadsheet, we see that by age 46 we have a portfolio of $1.06 million, generating an income of $106,000 a year. By age 69 we have a portfolio of $10.5 million, generating an income of $1.05 million a year. Well lookie here—we’ve got a seven figure residual income at age 69! If we want to keep going, by age 80 (which really isn’t that old anymore) we have a portfolio of $30 million, generating an income of $3 million a year.
If you download the spreadsheet, you can change the parameters to fit your current situation. In the first row, set the age to your current age, and set the portfolio value to what you actually have invested in stocks. Change the rate of return if you wish, and play with the amount invested annually to see what it does to the numbers.
This really does work, but the obvious problem is that it takes a long time (47 years to get a seven figure income in our example). Older people won’t have enough time to create a seven figure income this way, but even younger people can’t spend their whole lives just sitting there waiting for the money to add up. That’s why this is just one strategy at our disposal, and not the be-all, end-all of personal finance.
But at least now we can put behind us all this bunk about a six or even seven figure residual income being impossible. It’s actually quite easy, given enough time and some ability to save.
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(This post appeared in Carnival of Personal Finance 134: Building on the Basics, hosted by Mrs. Micah.)
January 3rd, 2008 at 5:00 pm
Hey Hunter, great article!
I found this extremely interesting, especially since I am 22 yrs old!
Many peoples’ attitudes about money are so backwards and ignorant that they will never even consider the vehicles to create wealth (such as this example) that we have all around us. It is amazing to me that the same people who complain about money all the time are the same ones who think about going to the mall the minute they receive a paycheck!
I have been procrastinating investing in an index fund for quite some time now, but this article has given me a real sense of urgency. I plan on making an initial $500 investment right away now.
Great perspective and great writing!
You have got to get a Stumbleupon button on your blog…I would have left you a review! Just yesterday, SU brought me 65 new visitors! Great tool for newbies like us!
I’ll be keeping an eye on your blog!
January 4th, 2008 at 12:20 am
Conrad, 22 is a great age to get into this! I was lucky enough at the age of 20 to receive a piece of mail addressed to the previous occupant of my apartment–a small newsletter with a single article about investing in mutual funds.
Being written during the dot-com boom, it assumed a 14% rate of return, which I later found out was not realistic in the long run. But it sparked an interest, and got me to do a lot more research over the years. I owe a lot to receiving that newsletter by chance (fate?).
Starting to invest at 22 will pay off big time down the road, no matter what amount you start with. The main thing is just to get into the habit.
BTW, as you can see, I added links for both StumbleUpon and Digg. Thanks for the tip!
January 7th, 2008 at 4:37 am
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January 9th, 2008 at 4:11 am
Great Post. I’ve included as one of my favorites from Carnival of PF. It’s fun with numbers and puts the power of aggressive savings and investing into perspective. All you whipper snappers out there, take a look, you’ve heard it before saving early and not that aggressively will pay off handsomely! This is the other half of the equation that makes sure you are worth your weight in gold! At 190 lbs at today’s gold hmmm, that’s a cool $2,402,208.00 Nice
January 9th, 2008 at 9:10 pm
Thanks, Teaspoon. It’s best if people discover this early, but it’s never too late to start. And being worth your weight in gold is a significant milestone, but maybe for most people it’s better to first shoot for being worth their weight in silver.
January 15th, 2008 at 9:35 pm
Hunter,
I can barely remember where I was when I was 22, but this is such great advice for the younguns. Like Conrad said, too many people are so focused on going to the mall, with their “ink isn’t dry on the check yet”, they forget to think about the future. But, as we age, and get closer to those “golden years”, we often have a wake up call that says, “what were you thinking?”
Speaking from maturity, (I won’t say old age), had we made investments (especially in real estate), when the offers presented themselves, we would be saying a lot less of “woulda, coulda, shoulda”.
Your advice is solid. Hopefully others will utilize that which you are sharing.
January 15th, 2008 at 11:37 pm
Barbara, the “woulda, coulda, shoulda” thing is hard to avoid. I’m sure there are people in their golden years who always invested every penny they could at the expense of never having fun, who look back on themselves and say “what was I thinking?” So it goes both ways. We have to decide how much of our cake we want to have, and how much we want to eat.
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May 1st, 2008 at 2:14 pm
Hi Hunter.
Interesting post. As a real estate guy, I’ve never been into the stock market as I feel profit gaining is too slow and I feel like my money is in the hands of someone else.
However, this is good advice for young people. They should start some kind of investment even before 22. The problem is most people that age have no interest in doing so and have the mentality of dealing with old age later.
I think parents should get it started for them and maybe one day pass it over to their children.
Being that I’m not a big stock market person, I’m curious, are there stocks that regularly produce a 10% annual return?
Thanks
John Hoff’s last blog post..How To Buy A House Like A Real Estate Investor: Part 3 – More On Dealing With Down Payments
May 2nd, 2008 at 5:26 am
Hi, John. You’re right, 22 year olds usually don’t have any interest in planning for the future. It’s unfortunate that they usually don’t start thinking about this until their 40s. That’s a good idea you have about their parents starting it for them.
I find real estate interesting, and I have a condo that I’m renting out. But I think doing well in real estate requires a lot of knowledge and effort. If that’s what you like to do, then great, you can probably do very well in real estate. But what I like about stocks is that you just dump the money in, do nothing, and collect the rewards (though it takes a long time). Of course stocks can go down, but the long term trend tends to be upward.
You asked if there are stocks that regularly produce a 10% annual return. Yes and no. On average, yes, large baskets of stocks have produced a 10% annual return over long enough periods of time in many cases. However, each individual stock can be all over the place. Take a look at this chart of the Coca Cola company:
http://finance.yahoo.com/q/bc?s=KO&t=my&l=off&z=m&q=l&c=
Wouldn’t it have been great to buy it in 1985 and sell it in 1998? It’s hard to tell exactly, but it looks like it would have turned $1,000 into about $90,000. On the other hand, if you had bought it in 1998, then by 2008 you would have lost about a third of your money. Coke has been a great investment over the decades, but that doesn’t mean you can expect it to be a smooth ride today.
Individual stocks are extremely volatile, which is why mutual funds are nice. With a single purchase, you’re buying shares of perhaps hundreds of stocks of different sizes in different industries, which helps to smooth out the bumps.
May 2nd, 2008 at 6:48 am
Hey Hunter. Thanks for that report on Coca Cola but to me it’s all a little confusing, but that’s just because I don’t know how to read stock charts. I should because I know stocks can be good, but it’s a little too volatile for me and like you said, can take a long time.
I think whether you go for stocks or real estate both take some knowledge and dedication to make it happen. Your article is a great example of why I think parents should start a fund when their child is born.
You’re the stock guy. What would $100/month invested into a CD or roth ira yielding a 4.5% return equal in 40 years?
I have two children (2 and 3 weeks old), I need to start something for them.
John Hoff’s last blog post..How To Buy A House Like A Real Estate Investor: Part 3 – More On Dealing With Down Payments
May 3rd, 2008 at 8:37 am
John, I ran the numbers for your scenario of a $100 a month investment at 4.5% for 40 years. To make the calculation easier, I assumed annual investments of $1,200 at the end of the year instead of monthly investments of $100. (Monthly investments would result in slightly more money than annual investments made at the end of each year, or slightly less money than annual investments made at the beginning of each year, just based on how long the money has to compound.)
The results: investing $1,200 at the end of each year, at a 4.5% rate of return, would result in $128,436 after 40 years. You would have invested $48,000 of your own money, so that means that you’d have a gain of $80,436.
However, we have to consider taxes and inflation. This is where low rates of return really kill you. If inflation is 4%, then your 4.5% return is a measly 0.5% in real returns. Factor in taxes (if it’s not a Roth), and your real return is probably negative!
May 3rd, 2008 at 12:43 pm
Thanks for the breakdown. You know, I wrote a blog article called “Understanding the Time-Value of Money.” This is the perfect example of how investors need to understand this principle.
As time goes on, the value of money decreases – mortgage companies understand this well.
From what I know about stock values, the average person investing in CDs and mutual funds can expect somewhere around a 4% – 6% return, is this correct? That’s why I mentioned that example.
John Hoff’s last blog post..How To Buy A House Like A Real Estate Investor: Part 3 – More On Dealing With Down Payments
May 4th, 2008 at 2:27 pm
John, a mutual fund is simply any fund where multiple investors pool their money. A mutual fund’s assets can be invested in money markets (maybe a 4% return, I’m not sure), bonds (maybe a 6% return), or stocks (maybe a 10% return).
As they say, past performance is no guarantee of future results, but this is roughly what history has shown so far. Performance can vary wildly, especially over short periods of time, and when a fund isn’t well diversified.
I don’t like to say that people should “expect” any particular return, but looking in the past, 4% – 6% could have easily been achieved with a mix of CDs and different types of mutual funds.
July 2nd, 2008 at 1:16 am
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August 31st, 2008 at 11:33 pm
Are there other real estate reference materials you recommend? Thanx
September 1st, 2008 at 1:21 pm
@ Real Estate Investor, sorry, I don’t really know much about real estate.
September 1st, 2008 at 1:28 pm
Try http://intellibiz.com/
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