For many of us, passive income is the holy grail of investing. It’s the process of turning our capital into a stream of income with very little activity from ourselves.
The problem is, if we’re starting with £10,000, we’re not going to be able to turn that into a significant passive income anytime soon. In fact, even the very best dividend stocks would only give me £800 a year from a £10,000 investment.
So how can we turn this starting point into a sizeable passive income?
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Trust the process
Essentially, I need to recognise it’s not going to happen overnight. I need to build a larger portfolio if I’m going to want a larger passive income.
First step is, therefore, contributing regularly to build my portfolio. This could mean taking as little as £50 a month and investing it along with my original £10,000.
Secondly, I need to recognise the importance of reinvesting my returns. This is a process called compound returns. By reinvesting every penny my portfolio generates, I can essentially earn interest on my interest, as well as my initial capital.
And finally, I need to understand risk management. While I can certainly exposure myself to more risk if I have a long-investment horizon, I need to realise I can lose money if I make poor investment decisions.
Stocks for growth…
If I’m investing for passive income in 25 years, I shouldn’t concern myself too much with near-term market volatility. Instead, my near-term goal is building my portfolio, and therefore it makes sense to invest in companies that are growing.
Of course, we can practice compound returns with dividend stocks. But if I’m investing for a date some distance into the future, I’m backing high-growth companies over mature dividend stocks.
For example, I’m investing in companies like AppLovin and Celestica with strong growth forecasts as indicated by their price-to-earnings-to-growth (PEG) ratio.
Let’s take a closer look at AppLovin. The stock trades with a PEG ratio of 0.65, showing that company’s growth could be undervalued by as much as 35%. The company, which helps platforms maximise their advertising revenue, surged in 2023. The stock is up 272% over 12 months.
Despite concerns of an economic downturn, AppLovin has gone from strength to strength. That’s on the back of improvements in artificial intelligence (AI).
…And for passive income
As I come closer to the date at which I want to earn a passive income, I’ll probably want to move my investments. I’ll go from the riskier, more growth-oriented stocks, to those that are more mature and pay a dividend.
In the current market, I’d be hard pushed to find a better option than Legal & General (LSE:LGEN). The insurer currently offers a 7.6% dividend yield with a dividend coverage ratio of 1.98. Insurers also tend to have particularly strong cash flows. Therefore they may find it easier to make dividend payments than some other sectors.
While Legal & General’s growth trajectory isn’t particularly exciting — it’s down 1.9% over 12 months — it’s benefitted from positive trends in bulk purchase annuities (BPA).
In fact, with only 15% of defined benefit pension liabilities transfers to insurers, the BPA market could continue to grow.
In conclusion, if I could grow my portfolio at 10% annually for 25 years before investing in 7.6% dividend yields, I could generate £14,136 annually.
