Warren Buffett’s idea of investing to generate passive income remains the holy grail of making money. It is simply: “If you don’t find a way to make money while you sleep, you will work until you die”.
For me, there is no more effective — and passive — way of making money than investing in high-dividend-paying shares. But they must be well-chosen, according to four criteria in my case.
Selecting the stocks
Each must pay dividends of at least 8%. Why? I expect to be properly compensated for supporting a company’s share price.
What is the proper level of compensation? It is whatever I think is adequate for the additional risk of buying a stock over the rate I can get by taking no risk.
This ‘risk-free rate’ commonly equates to the 10-year government bond of the country in which an investor lives. Currently, the 10-year UK government bond (known as a Gilt) yields around 4.2%.
However, the UK government-backed National Savings & Investments offers one-year fixed-rate Guaranteed Income Bonds yielding 6.03%.
Given the extra risk in stock investing, then, I think 8% is reasonable. However, several companies pay higher than that, so an average 9% yield across three or four stocks is obtainable.
To minimise these risks further, I usually only invest in FTSE 100 stocks, as these are the most regulated. I do not want one of my investments wiped out through some unexpected accounting revelations, after all.
My chosen companies must also have a strong business position in what I think is an undervalued sector. This should help mitigate the risk of an extended share price fall.
This will also be helped by choosing stocks that are undervalued compared to their peer group. I use several performance measurements to assess this, before trying to ascertain what a fair share price should be.
As part of this process, I also 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 other factors.
The dividend-compounding miracle
Like Warren Buffett, I use the dividends paid to me by a stock to buy more of it — known as ‘dividend compounding’. This means the size of my investments grows, paying me more and more in dividends over time.
It is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.
Using this technique, £8,000 invested at an average yield of 9% would produce a £75,267 investment pot after 25 years. It would yield £6,774 a year – or £565 a month.
The average yield might not remain the same over the period, of course. Stock dividends can fall (or be completely axed), as well as rise.
This also includes no further monthly investments.
However, if I continued to invest– say £500 monthly – I could have the same-sized pot in under eight years. After the full 25 years, the total pot could be £601,965 — yielding £4,515 a month!
