Savings sitting in a bank account can generate passive income. But while interest rates are more attractive now than they have been for a while, they could fall again in future.
So if I had a spare £25,000 in savings at the moment and wanted to generate passive income from it, my approach would be to invest it in shares. If I take a long-term approach to investing, I think I could ultimately aim for a monthly passive income of £1,000. That is £12,000 a year.
Here is how.
Investing in quality businesses
To start, I would choose some shares I thought had the income-generating characteristics I was looking for.
I would diversify to reduce my risk, so would spread the £25,000 evenly over five to 10 different shares.
But how could I know what sorts of shares might generate income in future?
My focus would be looking for businesses with a strong competitive advantage in an industry I expect to benefit from strong demand. If they can make big profits and do not need to invest them in their own growth, or use them to pay down debt, such firms might channel those profits to shareholders in the form of dividends.
Compounding
Still, even investing in such businesses, how could I hope to turn £25,000 into £12,000 of passive income a year?
To do that immediately, I would need a dividend yield of 48%. That is the stuff of investor fantasy!
Key to my approach would be reinvesting dividends. That way, the dividends themselves could effectively start to earn dividends. This sort of snowball effect is known as compounding – and it can be a valuable driver for investor returns over the long term.
At the moment, some blue-chip FTSE 100 shares like Legal & General offer a yield of around 8%.
Imagine I invested my £25,000 in a share portfolio with an average 8% dividend yield. After 25 years of compounding, it would be worth almost £160,000.
At that point, if I stopped compounding the dividends and started withdrawing them as cash, I should earn over £12,000 per year in passive income.
Setting expectations
A quarter of a century may sound like a long time to wait. Then again, I would be happy to do so if that meant I could turn £25,000 today into £1,000 per month in passive income down the line.
Dividends and share prices can go up but also down, so achieving an annual compound growth rate of 8% might be more difficult in future than it seems today.
Then again, it could also turn out to be easier. I would try to improve my chances of success by focusing always on buying into great businesses with attractive share prices.
