Making money while we sleep remains the pinnacle of the passive income idea. And to paraphrase Warren Buffett, if we don’t find a way of doing so we will work until we die.
The Sage of Omaha’s preferred way of doing this is to invest in companies over the long term. He also uses the profits he makes from his stock investments to buy more stock. This means the size of his investments continues to grow, paying more and more in dividends over time.
It is the same principle as compound interest in bank accounts, but rather than interest being reinvested, those dividend payments are.
Choosing the right stocks
One key element in this process is to identify companies that pay high dividends. Additionally crucial for me is that the stocks must be regulated and monitored to the highest degree.
After all, I do not want any nasty surprises wiping out one of my investments. So, I tend to invest solely in the top-tier FTSE 100.
Happily, this also happens to be the index that has offered the highest average returns since its creation in 1984. From then to the end of 2022, its total return (including average yield) was 7.48% a year.
However, there are currently many high-quality shares in the index paying more than that. My personal high-yield favourites include Phoenix Group Holdings (10.4% yield), Legal & General (8.4%), and Glencore (7.7%). Together, these have an average yield of 8.8%.
The third part of my high-yield stock selection process is to gauge whether a company is undervalued. I do not want my dividend gains wiped out by share price losses. I use several performance measurements before I then try to assess what a fair share price should be.
And finally, I look at the core strength of a business to determine if it is on a sustainable uptrend. This review includes short-term and long-term asset and liability ratios, new business initiatives, and senior management capabilities, among others.
Dividend compounding in action
If I put £10,000 into a selection of shares that paid dividends averaging 8.8% a year, I would receive £880. If I took those dividends out of my portfolio and spent them, I would only receive another £880 the following year.
This is provided that the average yield remained the same, of course. On the same proviso, and doing the same thing, over 10 years I would have made £8,800.
Not bad, but nothing compared to my returns if I used stock dividend compounding. By buying more of the stocks using the dividends paid to me, I would have a pot of £23,030 after 10 years. Again, assuming no change in the yield.
Subtracting the initial £10,000 investment, I would have made £13,030. This compares to just the £8,800 I would have made if I had taken the dividends and spent them.
Compounding the dividend payments in this way would give me a pot worth over £53,000 after 20 years at that 8.8% return. And after 25 years, the portfolio would be paying me £6,442 in dividends a year, or £537 a month in passive income.
Inflation would reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances.