You might think £20 a day is a bit of a weak passive income stream. But over a year, that’s an extra £7,300 of spare cash earned while you sleep. That would go a long way to covering a mortgage, building a retirement pot, or just funding an extravagant holiday.
So how can a UK investor build such an income?
Aiming for optimal growth
If you don’t already have a Stocks and Shares ISA, that’s a smart first step. Invest up to £20,000 a year in shares, ETFs or bonds without paying any tax on the capital gains or dividends. Seems like a no-brainer to me.
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.
Next, decide how much you need to invest each month depending on your timeline. For example, a 6%-yielding portfolio of dividend shares worth £121,666 could pay out £7,300 a year. Push that yield up to 7% and you’d need just £104,285.
Okay, it isn’t a small amount – but it’s achievable.
Let’s say you already have £10,000 in savings and put in an extra £300 a month. Stick to the plan, reinvest all dividends, and it could take 14-15 years.
Too long? Pump up your monthly contributions to £500 and it could take just 10 years. And that’s using a conservative annual total return of just 7%. Catch a few good years and hit a 9% average, that drops to just nine years.
That’s a short time period to build a big enough portfolio to earn decent income. But what’s the chances an average investor could pull that off? It all comes down to stock selection.
Picking top-quality shares
There’s a popular phrase: “past performance is not indicative of future results“. While this is certainly true, history still has a place. I’m more likely to trust a stock that’s been paying dividends for 20 years, than one that’s been paying for two years.
Any company can cut dividends at any time. Sometimes, it’s a necessary evil — if profits dip, cash must be preserved. But, ideally, they find ways to continue paying dividends no matter what — this builds trust, and attracts further investment. And the best are those that have grown dividends consistently. A solid, consistently-growing stock with a 4% yield can beat an unsustainable 7% yield over the long run.
For example, City of London Investment Trust (LSE:CTY) is a diversified fund that holds top FTSE 100 shares such as HSBC, Shell, British American Tobacco, NatWest, and Lloyds.
It currently yields around 3.9%, which is impressive when you consider it’s raised the dividend every year since 1966! That’s the longest unbroken growth record of any UK investment trust.
Naturally, its heavy exposure to the UK market puts it at risk. This is most evident in 2008 and 2020, when the price fell around 30%. If falling interest rates hurt bank profits, or an economic downturn hits UK-listed mega-caps, the share price could drop again.
Still, it’s risen at an annualised rate of 4.13% over the past 20 years. So when combined with the dividend, investors could expect an average total return a year of about 8%.
When combined with a few higher-yielding shares like Legal & General, that average would likely rise. So it’s clearly worth considering — but it’s not the only one to look at.
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Mark Hartley owns shares in City of London Investment Trust, HSBC, British American Tobacco, Legal & General, and Lloyds.
