Photo by Tracy O

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.

Age Portfolio Value Est. Annual “Income” 22 $0 $0 23 $12,000 $1,200 24 $25,200 $2,520 25 $39,720 $3,972 26 $55,692 $5,569 27 $73,261 $7,326 28 $92,587 $9,259 29 $113,846 $11,385 30 $137,231 $13,723 31 $162,954 $16,295 32 $191,249 $19,125 33 $222,374 $22,237 34 $256,611 $25,661 35 $294,273 $29,427 36 $335,700 $33,570 37 $381,270 $38,127 38 $431,397 $43,140 39 $486,536 $48,654 40 $547,190 $54,719 41 $613,909 $61,391 42 $687,300 $68,730 43 $768,030 $76,803 44 $856,833 $85,683 45 $954,516 $95,452 46 $1,061,968 $106,197 47 $1,180,165 $118,016 48 $1,310,181 $131,018 49 $1,453,199 $145,320 50 $1,610,519 $161,052 51 $1,783,571 $178,357 52 $1,973,928 $197,393 53 $2,183,321 $218,332 54 $2,413,653 $241,365 55 $2,667,019 $266,702 56 $2,945,720 $294,572 57 $3,252,292 $325,229 58 $3,589,522 $358,952 59 $3,960,474 $396,047 60 $4,368,521 $436,852 61 $4,817,373 $481,737 62 $5,311,111 $531,111 63 $5,854,222 $585,422 64 $6,451,644 $645,164 65 $7,108,808 $710,881 66 $7,831,689 $783,169 67 $8,626,858 $862,686 68 $9,501,544 $950,154 69 $10,463,698 $1,046,370 70 $11,522,068 $1,152,207 71 $12,686,275 $1,268,627 72 $13,966,902 $1,396,690 73 $15,375,593 $1,537,559 74 $16,925,152 $1,692,515 75 $18,629,667 $1,862,967 76 $20,504,634 $2,050,463 77 $22,567,097 $2,256,710 78 $24,835,807 $2,483,581 79 $27,331,387 $2,733,139 80 $30,076,526 $3,007,653

Amount Invested Annually $12,000 Rate Of Return 10%

(This post appeared in Carnival of Personal Finance 134: Building on the Basics, hosted by Mrs. Micah.)

Yes, that’s right, I won the lottery! Specifically, the Christmas Day drawing of Mega Millions. I matched one number plus the mega ball number to win $3.

Obviously, this is not a life changing sum, but it’s a good opportunity to reflect on my thoughts about the lottery.

I received ten $1 lottery tickets as a Christmas present. Seven of these tickets didn’t match any numbers. Two of them matched one number, but that doesn’t pay anything. And one of them matched one number plus the mega ball number, for a $3 payout.

Since the tickets were a gift, the $3 is pure profit. If I had bought the $1 ticket myself, it would have been a $2 profit. If I had bought all ten tickets myself, it would have been a $7 loss.

Two of the numbers on the winning ticket were only one off from a match. But even if I had been lucky enough to match three numbers and the mega ball, it would have only paid $150. A nice little bonus, but not much considering the chances of it happening are 1 in 13,781.

We all know the odds in the lottery are against us, but sometimes we forget just how much. The smallest significant prize is $10,000, and the odds of winning it are 1 in 689,065. This is less likely than the chances of being dealt a royal flush (1 in 649,739).

The smallest prize that could be considered life changing is $250,000, and the odds are 1 in 3,904,701. This is less likely than the chances that you’ll spot a UFO today (3,000,000 to 1).

The jackpot was $16 million, and the odds of winning it were 1 in 175,711,536. I wish I knew the odds up digging up $16 million worth of gold in your backyard.

The overall odds of winning any prize are 1 in 40. This is almost negligible compared to the odds of winning a prize on a hand of blackjack, which are roughly 1 in 2. Blackjack seems like a brilliant investment, by comparison.

Despite the odds, I think playing the lottery is OK if you see it as entertainment. If the fun and anticipation is worth $1 to you whether you win or not, then by all means do it. We all have entertainment expenses. Some lotteries supposedly support education, so if that’s true (and that’s a big “if”), and you want to support education, then that effectively reduces the cost of your entertainment.

But to me it’s not worth it. If I bought a $1 ticket, my fear of losing that dollar would be greater than the thrill of winning a modest prize.

I know this because I once participated in a Super Bowl pool at work (for the fun and camaraderie), paying $10 and winning a $100 payout for being randomly assigned numbers that matched the last digits of the scores at the end of the third quarter. The $90 profit was a nice feeling, but no match for my concern about losing $10.

The risk of the lottery dwarfs the risk of buying some stocks or starting a business. Any remotely reasonable investment is way, way more likely to pay off than the lottery, where a 100% loss is nearly certain on any given ticket. You’re also likely to learn something from the experience when you invest in something you have some control over. And people who win lottery jackpots are likely to lose it all.

Don’t invest in games of pure chance, invest in things that matter.

How can we quantify wealth in a meaningful way?

When people think about their financial situation, they often focus heavily on the numbers. But while an income of $100,000 a year might psychologically feel a lot better than $90,000, it’s really arbitrary and doesn’t make much difference in the here and now. What matters a lot more for your outlook on life is what the numbers actually do for your lifestyle.

I use the 6 levels of wealth to compartmentalize the many possible financial situations into 6 meaningful categories that we can work with.

Poor Level 1

At this level, you’re either homeless or a stone’s throw from being there. Your life basically can’t be made any worse by taking away money. Most people reading this have probably never experienced this situation.

Poor Level 2

You earn an income, keep a roof over your head, and pay the bills. You’re getting by, but not getting ahead. The money’s all gone at the end of the month, so you don’t seem to be gaining any ground. This is where people usually find themselves right out of school, and often for a very long time afterwards.

Poor Level 3

To others, you appear to be living the good life, and might be considered rich. However, you can only sustain the illusion by prostituting yourself (by which I mean having a job). Your lifestyle is completely dependent on your salary, and you live in fear of losing your job, knowing that the house of cards will come tumbling down.

Rich Level 1

Now we transition from financial dependence to financial independence. At this level, you may not have any fancy things, but you can maintain your lifestyle indefinitely without having a job. Your income from your business activities and your investments is enough to pay the bills, so you enjoy tremendous freedom from “the man.”

Rich Level 2

More than just getting by without a job, now you’re able to afford nice things as well. You might have a swanky house, exotic car, and so forth, or maybe you don’t need material things so you just save your money or give a lot to charity.

Rich Level 3

This is where professional athletes and Hollywood celebrities are, the level where you don’t even consider money to be a limited resource.

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Of course, these levels are not set in stone, and someone else could come up with an entirely different system that also made sense. But I think it’s important to think about where you want to be with your financial situation, and not just in terms of dollar amounts, but in terms of what your life would be like. I’m shooting for no less than rich level 1, with an ultimate goal of rich level 2. What about you?