3 simple ways to target passive income in the stock market

A passive income stream from the stock market can be a step towards greater financial freedom. Here are three strategies to pursue this in an ISA.

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The idea of generating passive income from stocks is incredibly appealing, as it allows me to receive money without having to actively work for it. And who doesn’t want that?!

Whether I’m looking to supplement my income or create a steady flow of future earnings, the stock market offers several strategies to achieve this.

Here, I’ll explore three of them.

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Immediate gratification

The first and most obvious way is to stick a lump sum into a few stocks and wait for the dividends to arrive in my investing account. Then I can spend the cash.

For example, let’s say I invest £20k (the annual ISA limit for tax-free gains) in a portfolio of five dividend stocks. If the average yield from these is 6%, then I’d expect to receive £1,200 in annual passive income.

I say ‘expect’ because individual dividends aren’t a surefire thing. Serious situations can develop — financial panics, wars, global pandemics — that force companies to cut or cancel their payouts. Firms can also run into individual difficulties.

Therefore, diversification‘s the name of the game when it comes to building a portfolio.

Fortuantely, UK investors are spoilt for choice when it comes to high-yield dividend stocks. There are nine offering yields above 6% in the FTSE 100, including banking goliath HSBC and insurer Aviva. There are a load more in the FTSE 250.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Reinvest dividends

The second strategy could be to reinvest the cash dividends I receive rather than spend them. This is called dividend reinvestment.

For example, let’s say I have £4,000 worth of British American Tobacco shares and they pay me the current 8.5% yield. This involves a quarterly dividend of 58.8p per share, meaning I’d receive around £85 every three months (or £340 a year).

Instead of spending this, I could use it to buy more shares. Then those would ideally pay me more dividends, and so on. This would harness the power of compound interest (the wealth-building magic).

Obviously, this is a form of deferred gratification. It involves reinvesting the payments to fuel compounding for a higher potential passive income in future.

Going for growth

The third way involves trying to build up my pot more quickly by investing in high-growth businesses.

One option today could be Uber Technologies (NYSE: UBER). I recently invested in the ride-hailing and food delivery giant, whose shares are up 25% in 2024.

Created with Highcharts 11.4.3Uber Technologies PriceZoom1M3M6MYTD1Y5Y10YALL28 Sep 201928 Sep 2024Zoom ▾Jan '20Jul '20Jan '21Jul '21Jan '22Jul '22Jan '23Jul '23Jan '24Jul '242020202020212021202220222023202320242024www.fool.co.uk

However, one risk I see here is the rise of autonomous vehicles (AVs or robotaxis). If these self-driving car firms build out their own consumer apps, Uber could one day be cut out as the intermediary platform.

To counter this, it has partnered with all the big AV firms, allowing them to tap into its massive 156m user base. But AVs remain a potential risk.

Still, after years of steep losses building market share, Uber’s profits are now motoring higher. In fact, analysts see earnings more than doubling over the next couple of years.

By 2026, Wall Street expects revenue of $58bn, up from $37.3bn last year. That’s high growth alright!

If my £20k portfolio made up of such stocks grows at 11% a year, I’d have £271,709 after 25 years. Then, if I switched to 6%-yielding dividend shares, I’d be receiving £16,302 a year in passive income.

Like buying £1 for 31p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

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.

HSBC Holdings is an advertising partner of The Ascent, a Motley Fool company. Ben McPoland has positions in Aviva Plc, British American Tobacco P.l.c., HSBC Holdings, and Uber Technologies. The Motley Fool UK has recommended British American Tobacco P.l.c., HSBC Holdings, and Uber Technologies. 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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