£20k inheritance? Don’t blow it: target a second income that pays £1k a month!

A £20k inheritance could be used to build a decent second income stream. Here, I provide an example of how a beginner investor could try to put £20,000 to good use.

Getting started

Opening an investment account is the first port of call on this journey. I think the best plan is to go with a Stocks and Shares ISA.

This enables investments in a diverse selection of assets, allowing for decent risk protection. It also means up to £20k can be invested a year with no tax levied on the capital gains. 

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.

Slow and steady gratification

Unlike a wild holiday to Ibiza, the gratification from stock market investing isn’t quite as immediate. However, those who are patience will find the long-term returns are well worth the wait.

By building a carefully constructed portfolio of shares, it’s realistic for a prudent investor to expect average annual returns of 7%. That means a portfolio worth £20k would return about £1,400 in the first year.

Only £1.4k? Don’t worry, it gets better. Thanks to the miracle of compounding returns, the annual returns grow exponentially over time. By the fifth year, it could be almost £2,000 and by the 10th year, over £2,700.

After 25 years, the investment could have ballooned to £114,000, returning over £7,700 a year — or £641 a month. However, withdrawing this each year would slowly reduce in value as inflation increases, so that should be accounted for.

One could also start withdrawing an extra £400 a month from the pot. Over time, this would reduce the pot and subsequent returns (but would still provide sufficient income for well over a decade). Yet the pot could also be shifted into a portfolio of high-yield dividend shares that provide a steady income without drawing down from the nest egg.

And of course, there’s the impact of adding more money to the investment regularly to boost the returns, plus the State Pension to take into account. Both of those would boost an individual’s income overall.

Shares to pick

It’s important to pick the right shares, or the average annual return could be below 7%. There is a risk that the portfolio could even return a loss in certain years. Many investors find that a good strategy to defend against this is to diversify into a mix of growth, defensive and income stocks.

One stock to consider is Diploma (LSE: DPLM), a multinational FTSE 100 company that specialises in the supply and distribution of technical products and services. Its diverse operations cover three sectors, including life sciences, seals and controls.

The price is up 157% in five years, indicating a strong history of growth.

Income-wise, its been increasing its dividends consistently for 23 consecutive years. However, its yield seldom rises above 2%, which is slightly below the average for the UK market. ​

It can also be highly sensitive to market expectations. The price fell 8% following recent results, despite solid financial performance. One possible reason is that a significant portion of the company’s growth is driven by acquisitions. When shareholders notice any missteps in integration or identification of targets, it can have a notable impact on the price.

Bolstering its defensive qualities, it spans multiple industries and geographies, providing a buffer against sector- and regional-specific risks.​ In the latest results, revenue rose 14% to £1.36bn and operating profits jumped 20% to £285m.