What is £20,000 worth? That might sound like a silly question. It is worth £20,000, now. But what if it could be worth over £40,000 in the future? Not as a sum of money, either, but as an annual second income?
I think that is possible. But turning a £20k lump sum into an annual income stream worth over double that (as well as a sizeable capital gain) is a serious project – it takes time and the right strategy. Here is how I would go about it, in three steps.
Step 1: move the money to the right place
My plan is all about earning income in the form of share dividends. So I need to be able to use it to buy shares.
To that end, my first move would to open a share-dealing account or Stocks and Shares ISA and deposit the money in it.
Step 2: spread it across five-to-10 blue-chip shares
Next I would invest the money evenly across five-to-10 blue-chip shares.
Why not just one? The unexpected can happen, so I need to spread my risk.
I would be looking for great businesses with attractive valuations, that I felt could generate surplus cash and pay meaty dividends regularly in coming decades. Yes, decades, not years.
Step 3: compound the dividends
I would reinvest the dividends by buying more shares. This is like a turbo charger to my (hopefully good) investment choices. Say that I can compound my £20k annually at a rate of 8%, after 42 years my portfolio should be worth over half a million pounds. If I can invest that to yield 8%, I would earn a second income of £40,543 a year.
I know – 42 years is a long time (or it seems so at the beginning, at least). Like I said upfront, this is a serious plan and it takes time. I could always start drawing my income earlier, in fact at any stage – it is just that I would need to settle for less.
So what sort of shares to buy?
The theory sounds all well and good. Over the long run though, an 8% compound annual growth rate is actually harder to achieve than it may sound. After all, we need to factor in the bad or flat years as well as the good and brilliant ones.
I think it is possible, if one selects the right shares.
Let me illustrate my approach by referring to the sort of blue-chip share I have in mind: Legal & General (LSE: LGEN).
Running through my blue-chip investment checklist: is it in an industry I expect to see large customer demand over the long run? Check. Does it have a competitive advantage? Check, thanks to an iconic brand and existing customer base. Is the valuation attractive in my opinion? Check, the market capitalisation of £13.4bn looks good to me.
What about the risks? One I see is a financial crisis badly hurting demand just as asset valuations sink. That could see a dividend cut, as happened in the last financial crisis.
The dividend yield is 9.1% and over five years the share price has moved down 2%. I am upbeat about its future.
