Investing in quality shares with high yields remains the truest method of generating passive income, in my view.
It does not involve things like dealing with tenants or estate agents occasioned by renting out property, for example. Nor does it entail the considerable effort of maintaining some sort of social media channel.
All it requires is picking a few high-yield shares in a well-regulated stock market and periodically monitoring their progress.
My core passive income picks
The longstanding core of my passive income portfolio aimed at maximising my dividend income are four financial sector stocks. These are abrdn, M&G, Phoenix Group Holdings, and Legal & General.
Aside from my view that the sector has been unfairly undervalued since the 2016 Brexit vote, these stocks have other qualities in common.
One is their high yield relative to the current FTSE 100 average of 3.6% and the FTSE 250’s 3.3%. abrdn currently yields 9.9%, Phoenix Group 9.6%, M&G 9.5%, and Legal & General 9%.
Another quality is they all appear undervalued against their peers on one or more of the key measures I use. And the third quality is that they all seem to me to be set for good growth.
A new addition to my portfolio
Recently, I added HSBC (LSE: HSBA) to this set of holdings.
Its current yield of 7.2% is a lot less than the other four stocks. However, it is predicted to rise this year to 9.9%, including a special dividend of 21 cents (16p).
It also looks cheap compared to its competitors. On the key price-to-earnings ratio measurement, it trades at just 6.9, against a peer group average of 7.6.
Moreover, a discounted cash flow analysis shows HSBC to be 60% undervalued at its current £6.54. So a fair value would be £16.35, although it might go lower or higher than that.
In terms of growth, analysts expect revenue to increase by 3.1% a year to end-2026. This is lower than in the past five years, as its net interest margin is projected to fall along with UK rates.
This margin is the difference between interest on loans and deposits, and its decline remains the main risk for the bank in my view.
Generating big passive income
I started investing around 30 years ago with £9,000. So, investing that now in HSBC would make £648 in the first year.
Over 10 years on the same yield, this would rise to £6,480, and over 30 years to £19,440. This would be paying £1,340 a year in passive income at that point, or £112 each month.
A nice return certainly. But it is nothing like what could be made if the dividends were used to buy more HSBC shares.
Doing this (known as ‘dividend compounding’) would generate £9,450 after 10 years, not £6,480. And after 30 years, it would increase to £68,538, rather than £19,440!
Adding in the initial £9,000 stake, this would pay £5,583 a year in dividends, or £465 a month.
Assuming inflation over the period, the buying power of the money would have been reduced by then.
However, it shows what big passive income can be made from much smaller investments over time, especially if the dividends are compounded.
