We’d all love to generate passive income, right? Naturally, it’s something of a privilege — the ability to earn money by doing almost nothing at all.
But to generate passive income, we’ve got to have a pot of money to invest. So what if I had £20k in cash, how could I use this to generate a life-changing amount passive income?
The starting point
Firstly, of course, I could look at getting a buy-to-let property and use that money as my deposit. But while it can be lucrative, being a landlord isn’t exactly ‘passive’. I’ve done that and the returns weren’t good enough, plus my money was locked away in property.
I prefer to invest in stocks. And I can do this simply by opening an account with a broker, such as Hargreaves Lansdown — it only takes minutes.
Using the Hargreaves Lansdown platform, I can open a Stocks and Shares ISA. This allows me to make investments in a tax-free environment.
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.
Investing
If I invested £20,000 today, even in some of the largest yielding stocks on the FTSE 100, I’d only receive around £1,600 a year in passive income. That’s fine, but it’s clearly not a life-changing sum. I’m looking for £20k a year!
Instead, if I wanted to earn £20,000 a year from my initial investment, I’d need to practice something called compounding, or a compound returns strategy. This is essentially the process of reinvesting my returns every year.
By doing this, I’ll start earning interest on my interest. Thus the growth rate increases over time. So the longer I leave it, the faster it will grow.
Compounding
When it comes to compounding, we normally say that we should be investing in dividend stocks. For example, I could invest in a stock paying a 5% yield — which isn’t guaranteed — and then I would reinvest that dividend when it’s paid year after year.
But in reality, some businesses do the compounding for us. What I mean is, instead of paying a dividend to their shareholders, they continue to invest their profits in their business. Several US-based tech companies have done this, like Amazon and Apple — they’re now trillion-dollar companies.
But it’s easier to practice compounding with dividend stocks. After all, it means I have the power to reinvest my money, not some executive in San Fransisco. Plus, while dividends aren’t guaranteed, they’re more reliable than share price gains.
The power of reinvesting
Well, to generate £20,000 a year, I’m going to need at least £250,000. That’s because I could invest £250k in dividend stocks, like Legal & General with its 8% dividend yield.
So how do I get there? Let’s imagine I’m able to achieve low-double-digit annualised portfolio growth, say 11%. That’s slightly above the FTSE 250‘s average annual growth of 10.6% recorded between 1992 and 2022.
Assuming I can actualise an 11% growth rate, it would take me 23 years to turn my £20k into £250k. That might sound like a long period of time, but it would be worth it.
I can also help my portfolio growth by contributing more funds on a monthly basis. If I added just £200 a month, I could reach £250k in just 17 years.
