What’s the best way to generate a passive income from stock market investments? The obvious answer might be to buy shares that pay dividends. And that is the cornerstone of my investing approach.
Dividends do make it very convenient to take income. They just show up as cash, which I can spend how I please. But can I boost my returns by looking beyond today’s biggest dividend yields?
I’ve been reading some statistics from AJ Bell, which looked at total returns and not just dividend income. And companies that have lifted their dividends every year for a decade have produced some stunning total returns, even based on modest dividend yields.
Passive income from total returns
Those companies, on average, produced total returns of more than 800% between 2011 and 2021. The FTSE 100 managed just 90%. That’s thanks, in part, to progressive dividends. And here’s how it works.
Suppose I buy some shares at 100p today, and they pay 4p per share in dividends. That’s a 4% yield, very close to the FTSE 100 average, and not too exciting.
But if the company can raise its dividend by 5% per year, after 10 years it will be paying 7p per share. And after 20 years, it will be up to 11p. So my effective yield, on my original purchase price, will grow to 7% and then to 11%. That’s progressive passive income.
Progress dividends safer?
In my experience, the kind of companies that pay modest yields while raising them year after year tend to be among the less risky investments. I’m thinking of companies like National Grid (with a 10-year total return of around 200%), and Diageo (on more than 250%).
As an example, let’s examine London Stock Exchange Group. The forecast dividend yield stands at a meagre 1% for 2022. So it’s not an obvious candidate for generating much in the way of passive income.
But the share price has soared by more than 700% over the past decade. And that, in turn, has been driven by strongly progressive dividends. The 95p paid in dividends in 2021 is equivalent to a 10% yield on the share price of 10 years ago.
How to split £10,000
How would I allocate my £10,000 for generating passive income? There are 16 stocks in the FTSE 100 with 10-year dividend growth records, and I’d target those specifically. I’d go for a diversified selection of between eight and 10 of them.
In fact, I can’t help wondering how just buying the top 10 with the best returns might work out. I’ll leave that for another day.
These returns I’ve quoted are not predictions of what is to come, and there are always risk with any investment. But I’m using them here to illustrate how seeking modest but progressive dividends, rather than one-off high yields that are perhaps unsustainable, can help generate superior total returns for greater passive income.
