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How I’d build passive income starting with just £500

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One joy of long-term investing is watching my passive income roll in. This is unearned income. One great thing about passive income is it works when I don’t — even while I’m sleeping. Indeed, as billionaire investor Warren Buffett once put it: “If you don’t find a way to make money while you sleep, you will work until you die.”

Now imagine this: having enough passive income to retire early and only do the things you want to. Earlier this year, my wife and I considered early retirement at 52, but changed our minds. After all, why quit work when Covid-19 restrictions prevented us from travelling? And where did our income for retirement until death come from? From years of patient investing in income-generating assets. Here’s how I’d start out again today with an initial investment of just £500.

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Passive income: cash and bonds aren’t for me

In this world of ultra-low and negative interest rates, finding decent income-generating assets is really tough. For example, top-paying savings accounts only pay between 0.5% and 2% a year, before tax. Frankly, I’d find it nearly impossible to build wealth by saving at such low rates of interest. Thus, I’d ignore cash as an asset for generating passive income.

Likewise, after a 40-year bull market, safe government and company bonds (fixed-interest IOUs) also offer very low yearly yields. For example, a 10-year Gilt (UK government bond) pays a yield of 0.88% a year. Hence, I would also avoid bonds when investing for passive income. And the same goes for domestic property. With UK house prices at record highs, rental yields look unimpressive to me today.

Share dividends are my #1 passive income

More than 35 years of investing has taught me one powerful truth. Over time, few assets beat the returns on offer from stocks and shares. Such equities offer me two ways to make money. First, from capital gains (selling shares at a profit). Second, from dividends (regular cash payments from companies to shareholders). That said, company dividends are not guaranteed, so they can be cut or cancelled at any time. Even so, cash dividends account for as much as half of the long-term returns from the UK stock market.

Investing in dividend shares

There are over 2,000 companies listed on the London Stock Exchange, but most don’t pay dividends. In fact, the vast majority of UK dividends are paid by members of the blue-chip FTSE 100 index. Indeed, investment platform A J Bell expects FTSE 100 firms to pay cash dividends of £84.1bn in 2021. However, the vast majority of FTSE 100 dividends come from a handful of  big businesses. Just 10 huge firms account for more than half (55%) of all FTSE 100 dividends, while the top 20 account for almost three-quarters (73%) of the total.

Hence, if I were starting out today, I’d invest my £500 across two or more of these mega-dividend payers. I’d then add more dividend stocks to my portfolio with each extra £500. Also, I’d diversify to spread my risk across different shares as I go, to reduce my portfolio’s concentration. And I’d reinvest my dividends into buying yet more shares (what I call ‘snowballing’). And then I’d sit back and hopefully watch my passive income come a-rolling in, although I have to note that this isn’t guaranteed. Companies can face problems and cut or cancel their dividends.

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Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

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