I am aiming to generate a passive income from my investments in the long term. The approach I am using for this is relatively straightforward. I have a set level of income I want to achieve every month, and I am investing in companies that may help me hit this target.
The level of income I want to achieve covers my monthly outgoings. This figure will, of course, vary from person to person. But for the sake of this article, I am going to use a set figure of £500 a month.
According to my calculations, to generate a passive income of £500 a month, I would need to build an investment pot worth around £150,000. If I can generate an average dividend yield of 4% on my investments, it would be possible to earn £500 a month or £6,000 a year.
Unfortunately, one significant drawback of using this approach is that dividend income is never guaranteed. Dividend income is paid out of company profits. Therefore, if profits drop, management may reduce the dividend.
This is just what happened last year, and it caught many investors by surprise. However, this is a strategy I am entirely comfortable using for my passive income portfolio.
Investing for passive income
To try and reduce the impact a dividend cut may have on my portfolio, I invest across the income spectrum. By this, I mean I invest in a selection of high yield and low yield companies to achieve an overall dividend yield of 4%.
On the high yield side of the passive income portfolio, I would buy stocks like Diversified Energy, Persimmon, and Sabre Insurance. These stocks offer dividends yields between 6% and 10%, which look incredibly attractive in the current interest rate environment.
However, this high level of income signifies all three companies are struggling to find investment opportunities, so they are returning cash to investors. This could imply that while these equities are income champions today, capital growth could disappoint in the long run.
At the other end of the spectrum, I would buy the London Stock Exchange Group, Rentokil, and Croda. All of these stocks offer dividend yields of between 1% and 1.3%. That is not much in the grand scheme of things, but they are also all heavily investing in growth opportunities. This could yield capital growth and dividend growth in the long run, although it is not guaranteed.
The final basket of companies I would buy for my passive income portfolio are those in the middle of the road.
This would include businesses such as DFS Furniture, Tate and Lyle, and BAE Systems. All three of these stocks support dividend yields of around 4%. This implies they are striking a good balance between income and investing for growth. That is why I would want these middle-market companies in my passive income portfolio.
The bottom line
By following the approach outlined above, I believe I could generate a passive income of £500 a month. That is assuming I have an initial pot of £150,000 to begin with.
Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has recommended Croda International. 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.