I firmly believe that one of the best ways to generate a passive income is to invest in stocks and shares.
This is not the only strategy I can use to generate a passive income. Indeed, I could use plenty of other techniques, but many of these require substantial initial investments.
For example, with the average property price in the UK currently sitting at around £270,000, to generate passive income from buy-to-let property, I would need a deposit of more than £100,000 to get started.
By comparison, I can start buying stocks and shares with an investment of just £50 a month.
Equities for passive income
Another advantage of using equities to generate income is that I can invest across sectors and industries with relatively little upfront capital.
Thanks to the rise of low-cost trading apps in recent years, it is possible for me to spread my investment across a range of different companies with just a few clicks and without having to pay hefty trading fees.
I can invest my £50 in companies across the financial and consumer goods sectors in a couple of minutes. Achieving the same sort of diversification from other passive income streams is virtually impossible.
Unfortunately, income from equities is never guaranteed. This is probably the most significant risk of my equity passive income strategy.
Significant risks
I will be looking for dividend stocks in my passive income portfolio, but dividend income is paid from corporate profits. Therefore, if profits drop substantially during any period, the enterprise may eliminate the payout.
This happened in 2020 when companies suffered a significant drop in income during the coronavirus pandemic. Tens of billions of pounds were cut from dividend payouts across the UK, leaving income investors in the lurch.
Luckily, this trend has reversed as the economy has reopened. Nevertheless, it shows one of the main risks of using this strategy to generate passive income. Other income strategies may not involve the same risks.
Despite this risk, I am comfortable using the strategy to generate a passive income. I think the benefits far outweigh the risks. And I think it is possible to generate a passive income for life using an initial investment of just £10,000.
Lifetime income stream
An investment of £10,000 could be enough to start generating a passive income straight away. At the time of writing, several companies on the market offer dividend yields of 8% or more.
If I were to invest this money in a portfolio of corporations yielding 8% on average, I could generate a passive income of £800 a year. This is a start, but it would only make a minimal impact on my overall finances. If I want to generate a meaningful income, I will have to invest a lot more.
With this being the case, rather than investing for income straight away, I would take my £10,000 and invest it in a portfolio of growth stocks. Combined with additional contributions along the way, I think I could significantly increase the overall investment balance, allowing me more room to create an income stream in the future.
Over the past couple of decades, the UK equity market has produced an average annual return for investors in the region of 8%. Past performance should never be used as a guide to future potential. Still, if I can achieve a return around this level, I can increase my capital significantly over the next couple of years.
I plan to do this by investing in a selection of individual companies and investment trusts to build exposure to different parts of the market and different growth stocks.
Robust competitive advantages
I am looking for companies with strong competitive advantages. I am also searching for firms with a track record of earning high-profit margins consistently and returning cash to investors.
A great example is tabletop gaming company Games Workshop. The organisation operates in a niche market with a unique customer base, allowing it to earn relatively high-profit margins. This, in turn, gives the enterprise more headroom to return cash to investors.
A growth trust I would buy is the BlackRock Throgmorton Trust. This trust aims to seek out the UK’s most ambitious and exciting small companies.
While the strategy of picking growth stocks and funds may allow me to achieve higher returns on my money, it does come with some risks. The most important being that this strategy could hurt returns if these companies do not live up to expectations.
If returns do come in below expectations, I may have to save for longer before I hit my wealth target.
Still, despite the risks, I am comfortable using their strategy to grow my nest egg. According to my calculations, if I can achieve an average annual return of 8% on my money, with additional contributions of £250 a month, I could turn my initial investment of £10,000 into a lump sum of £70,000 after a decade.
Of course, these are just ballpark figures. There is no guarantee I will be able to achieve this return. However, I think they illustrate the wealth-creating potential of stocks and shares over the long run.
Growth to income
When I hit this target I plan to switch from growth investing to income investing.
By investing the £70,000 in a portfolio of companies like British American Tobacco and Direct Line, which currently support an average dividend yield of around 7%, I believe I can achieve a return of nearly £5,000 a year in passive income. There are plenty of other income options available on the market at the moment. Still, these are some of my favourite income stocks on the market right now.
That is the plan I will use to generate a passive income for life with an investment of £10k. It might not be perfect, and it certainly has some drawbacks. Nevertheless, I believe this approach could be one of the best ways to build wealth in the long run.
