The stock market can be an excellent source of passive income. By capitalising on cheap, high-yield dividend stocks, investors can build chunky amounts of wealth, even with modest amounts of capital.
In fact, with just £300 a month, it’s possible to establish a six-figure portfolio, generating a second income of £21,000. Here’s how.
Building wealth in the stock market
The London Stock Exchange may not be filled with the latest ground-breaking tech stocks, but it’s home to lucrative income opportunities. Of the 100 companies in the FTSE 100, 95 currently pay dividends. And 24 offer a yield of more than 5%.
As a whole, the index currently offers an average yield of 3.7%. But by being selective and picking individual stocks, achieving an average yield of 5% is entirely possible without needing to take on excessive risk.
At this rate of return, an investor seeking to generate £21,000 each year, or £1,750 a month in passive income, would need a portfolio worth roughly £412,500.
Obviously, that’s not pocket change. But through compounding, investing just £300 a month, which roughly translates to £70 a week, it’s possible to establish this chunky nest egg in the long run.
Since its inception, the FTSE 100 has delivered a total shareholder return of around 7.6% a year. And by tapping into a low-cost index fund, investors could theoretically hit the six-figure threshold within just 30 years. At this point, they can transfer their capital from an index fund into individual stocks to achieve their target income stream.
Passive income from stocks has risks
While the maths can paint a rough timeline of the wealth-building process, investors may have to wait far longer, in practice. That’s because there’s no guarantee the UK’s flagship index will continue to deliver the same returns moving forward. And even if it does, a single badly-timed stock market crash, or correction, can undo years’ worth of work.
But even if the FTSE 100 behaves as expected, a new risk is introduced when picking individual stocks. Investors can’t just buy the highest-yielding enterprises they can find. In fact, this approach would likely destroy wealth rather than create it.
Why? Because a high yield is usually a sign of weakness rather than strength. And some of the largest yields on the London Stock Exchange are caused by rapid share price declines rather than sudden surges in earnings.
Of course, this risk can be managed. Diversification is just one method that helps mitigate the impact of any single company failing to keep up with shareholder payouts. And by carefully investigating and analysing businesses, it’s possible to filter out the duds and establish a portfolio of reliable dividend stocks set to generate a chunky passive income for decades to come.