How I’d aim to turn £10,000 into £5,494 a year of passive income

I’m a big fan of passive income. Generating a revenue stream with the minimum of effort appeals to my innate laziness.

I’m going to assume that I have £10,000 at my disposal. This is a lot of money to find. Whether obtained through inheritance, selling an asset, saving hard, or pure luck, my plan requires a large upfront sum.

The alternative of drip-feeding smaller amounts should achieve the same result, but it’ll take longer to reach my income target.

Too much choice

The next problem to overcome is how to spend my money.

There are nearly 60,000 listed companies in the world. That’s far too many for me to analyse. Also, I’d rather invest in UK shares as these companies are more familiar to me.

But that still leaves nearly 2,000 securities on the London Stock Exchange to choose from.

To keep things simple, I’d buy a tracker fund. This type of investment product seeks to replicate the performance of an entire index or group of stocks.

Buying a tracker is a great way of achieving a diversified portfolio from owning one stock. My cash is then spread across a range of companies and isn’t dependent upon the fortunes of a few.

That’ll help me sleep at night.

Another decision

But what should I track?

I don’t like taking unnecessary risks so I’m naturally inclined to invest in FTSE 100 stocks. In theory, these companies are less likely to go bust, although this isn’t guaranteed.

By a happy coincidence, the FTSE 100 has out-performed other major UK indexes over the past five years, assuming that dividends are reinvested.

During this period, we’ve had a global pandemic to deal with. This has suppressed the performance of the UK stock market. Look back 10 years and the annual growth rate will be higher.

But I’m going to assume that my £10,000 will grow by 4.9% each year.

However, history might not be repeated. As Warren Buffett wryly observes, if the knowing about the past was a way of making money, all librarians would be billionaires!

But I can’t see into the future, so I’ve nothing else to guide me.

Anyone who’s 21 is currently due to receive the state pension when they’re 68. Therefore, for the purposes of this exercise, I’m going to assume that I’ve got 47 years of investing ahead of me.

Over this period, my initial £10,000 could grow to £94,721.

Now what?

To start generating passive income, I’d sell my tracker fund and buy a handful of individual FTSE 100 stocks.

AJ Bell publishes a quarterly dashboard that includes dividend forecasts for 2023.

The latest prediction is that 10 stocks will pay 55% of FTSE 100 dividends this year. These are not necessarily the highest yielding shares but they are the stocks — in cash terms — that are expected to pay the largest dividends.

The average of these yields is 5.8%, which means I could generate £5,494 in passive income each year without touching my capital.

Dividends are never guaranteed. By investing in the largest companies, though, I’d hope to mitigate the downside as much as possible.

Unfortunately, I’m not 21 anymore. But I’ve been investing for a while now and I’ll hopefully be able to generate a similar level of passive income when I retire.