I am targeting a monthly passive income of £500, or £6,000 a year to put it another way.
This will not be possible overnight. Depending on how much I save every month, and the performance of my investments, it could take anywhere from a couple of years to a couple of decades.
However, no matter how long it takes me to reach this target, my strategy will not change.
Passive income strategy
According to my calculations, to hit this target, I will need to build a savings pot of £100,000. That is assuming I can then invest this cash in investments yielding around 6%.
As noted above, the time it takes to hit this target will vary greatly depending on how much I can save. If I can put away £5,000 a month, I could build a £100k nest egg in a couple of years, depending on the performance of my investments.
If I save £1,000 a month, it will take around eight years. And If I put away £500 a month, it will take more than 10 years.
The big unknown in all of these figures is the performance of the investments I acquire.
Over the past couple of decades, the UK stock market has produced an average annual return of around 8%. Past performance should never be used as a guide to future potential. Nevertheless, I think I can use this figure as a rough benchmark for potential returns.
On that basis, assuming I invest my money in a low-cost market tracker fund, I reckon it would take 11 years to build a £100,000 pot with a monthly investment of £500.
It would take seven years to hit the same level with a monthly investment of £1,000. And just under two years with £5,000 a month.
These are just estimates based on the potential market return.
Investing for income
After building my £100k lump sum, I am going to switch from growth to income investing.
To hit my 6% yield target, I will invest in a basket of high yield stocks.
I will buy companies like British American Tobacco and Persimmon, both of which currently offer dividend yields of around 8%. Phoenix Group and Legal & General could also be attractive investments. They both support dividend yields of about 6%.
By acquiring a diversified portfolio of stocks, I believe I can increase my chances of hitting my £6,000 a year or £500 a month passive income target.
However, there are risks with the strategy. Dividend income is never guaranteed. Dividends are paid out of company profits, and if profits suddenly drop, corporations have no choice but to cut their distributions. As such, my passive income stream could collapse in an economic slump. The figures above also exclude the impact of tax on dividend income. This is something I will also have to take into account.
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Rupert Hargreaves owns shares of British American Tobacco. The Motley Fool UK has recommended British American Tobacco. 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.