Building a portfolio to generate passive income is one of the most common investment goals. And by investing sensibly, over time it’s possible to leverage the stock market to turn a limited pool of capital into a second income stream.
So let’s explore how I could turn £100 a week into a passive income stream worth tens of thousands a year.
Going long with UK shares
Between 1984 and 2019, the FTSE 100 rose by 654%, and by 1,377% on a total return basis. On an annualised basis, this amounts to an annual price return of 5.8% and an annual total return of 7.8%.
So let’s imagine I’m aiming for £40,000 in passive income a year. In which case, I’d need to have £1m in stocks paying on average a 4% yield. That yield is certainly achievable. But what about the £1m?
My plan to turn £100 a week, or £434 a month, into £1m revolves around a compound returns strategy. This is essentially the process of earning interest on my interest by reinvesting my dividends year after year.
It may not sound like a winning strategy. But essentially, the longer I reinvest for, the more money I’ll have in the end because the returns grow exponentially.
Of course, I appreciate that finding a little over £5,000 to invest in stocks and shares isn’t easy for everyone. However, it’s part of a process that will pay off in the end.
Let’s imagine I can just beat the average index returns. So I invest in dividend stocks and aim for an 8% annualised return. Remember that’s only 0.2% above the average.
After 35 years of investing £100 a week, while reinvesting my dividends, I’ll have just over £1m. And, hopefully, by the end of the period, the weekly £100 commitment will feel a lot easier.
In fact, I could actually increase my weekly contributions in line with inflation, or in line with my own salary growth. If I increased my contributions by 5% a year, after 35 years I’d have £1.76m.
That clearly could be something worth considering.
So if I started drawing passive income after 35 years, and my average dividends were 4%, I could generate £40,000 from £1m, or £70,400 from £1.76m.
Things don’t always go to plan
No investment is risk-free. I could end up losing money so I need to have my wits about me and avoid making risky decisions.
One thing I need to be wary of when applying a compound returns strategy is big dividends. Sometimes they can be too good to be true. For example, Persimmon‘s yield reached 20% as the share price collapsed in late 2022. That’s huge, and it looked like a warning sign.
One way of checking is looking at the dividend coverage ratio. Persimmon coverage in 2021/2022 was just over one, meaning it only just had the income to pay it’s stated dividends.
In the end, the dividend was cut. The signs were right.
As such, for my own portfolio, I’m looking at safer parts of the market with attractive but sustainable yields.
I’ve bought Lloyds, Legal & General and Hargreaves Lansdown and think they’re good starting points. Collectively, I see them providing the dividends and sustainable growth required to make my strategy work.
