Today I came out from under my rock to see what was happening in the financial world, and found that today was one of the worst days of the financial meltdown. I found myself thinking about Martha Stewart, and wondering whether insider trading should have been included as the seventh income stream in Online Business School.

Seven years ago, Martha sold all of her ImClone stock on insider information the day before an 18% drop, avoiding a loss of $45,673. She denied it when questioned, saying “I just want to focus on my salad.” But sure enough, she was eventually convicted of conspiracy, obstruction of an agency proceeding, and making false statements to federal investigators. She was given a free five-month vacation in Camp Cupcake, and fined $30,000.

I didn’t follow this story closely, but am I missing something here? Did she actually profit from the deal, even after the conviction? I’m not an economist, but it seems that one good way to reduce the deficit is by raising the “insider trading tax.” I’m not a big fan of taxing the rich just because they’re rich, but if they’re guilty of illegal riches, can’t they share the wealth a little?

Below are the lyrics I remember from the parody song “Martha,” to the tune of Barry Manilow’s Mandy. I heard it on the radio years ago, but I can’t find it online. I wish they did a video, because it really loses a lot without the tune.

She got an inside Wall Street tip
Now she’s gonna pay for it
Her broker says she lied
She’ll soon be indicted
She’s facing lots of time
And we’re so excited

To see her walking out in cuffs
Twenty years won’t be enough
Dress her up in stripes
Send her to Sing Sing
Keep her there for life
It would be a good thing, oh Martha

Well they’ll get you for insider trading
Then they’ll send you away, oh Martha
When we’re laughing so hard that we’re shaking
What’s your stock worth today, oh Martha

You had everything and you spoiled it
Now they’ll lock you away, oh Martha
Pretty soon you’ll be sharing a toilet
With your cellmate

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.

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