No passive income? I’d buy UK shares now to unlock the power of compound interest!

There has rarely been a better time to start building a passive income portfolio of dirt-cheap dividend shares listed on the London Stock Exchange.

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If I want to invest in explosive growth companies changing the world, then I’m heading to the US stock market. That’s where Amazon, Tesla, Nvidia, and the rest are listed. However, if I’m aiming to generate attractive levels of passive income, then I’m looking no further than dirt-cheap, high-yield UK stocks.

Why the UK stock market?

Put simply, I get more bang for my buck (or pound) in the UK when it comes to dividend yields. At around 4%, the average FTSE 100 yield is more than double that of the S&P 500.

But that doesn’t tell the whole story. That’s just the average. Pop the bonnet and look more closely, and we can find yields far in excess of 4%. Here’s a quick snapshot.

Dividend yield
Phoenix Group9.4%
Legal & General 8.6%
British American Tobacco8.5%

Now, the reason some of the yields are so high is because the share prices have struggled. But that doesn’t mean the businesses are floudering, far from it.

Indeed, these firms have mostly been upping their shareholder payouts for years, propping up those high yields in the process.

Passive income generation

Right now, a quarter of FTSE 100 stocks carry yields above 5%. That means it’s entirely possible to build a diversified portfolio yielding an average 7.5%. That’s higher than I’m going to get in any savings account, even after interest rates have marched higher.

Therefore, I could invest £20k in an ISA right now and aim to receive annual passive income of £1,500.

However, if I reinvested my cash dividends for a few years instead of spending them, my £20k would more than double to around £41,220. And the passive income potential would also double as a result.

Of course, this is assuming stable share prices over that period, which is highly unlikely. After all, stock prices do fluctuate, even though overall markets trend upwards over time.

So I may end up with less than I originally put in, even after dividends, which themselves are never guaranteed.

However, there is one way to minimise these risks.

The magic of compounding

Instead of investing a lump sum, I could adopt a pound-cost-averaging approach. That is, I could invest regularly at set intervals, say monthly. That would mean drip-feeding my £20k into shares over a 12-month period. That would smooth out the natural ups and downs of the market, providing greater peace of mind.

Better still, I could commit to invest month after month, reinvesting all the dividends that I receive along the way. Then, I would start to really harness the power of compound interest, which means earning interest upon interest.

For example, if I were to invest £500 a month on top of my £20k, I’d have about £221k after 15 years. That’s assuming the same 7.5% return. And I could then hope to unlock annual passive income of £16,500 from this sizeable portfolio.

Admittedly, this compounding approach would need discipline as my total amount piled up. After all, it might be very tempting to dip into my growing six-figure pot to fund, say, a lavish holiday.

But as investing legend Charlie Munger cautions: “The first rule of compounding is to never interrupt it unnecessarily“.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Ben McPoland has positions in Legal & General Group Plc, Nvidia, and Tesla. The Motley Fool UK has recommended, British American Tobacco P.l.c., M&g Plc, Nvidia, and Tesla. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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