I think the stock market has great potential as a source for creating a passive income. Many companies pay shareholder dividends. And if I choose stocks backed by strong businesses, often that stream of dividend income can grow by increments year after year.
How I’d use stocks for passive income
Of course, not all companies listed on the stock market are backed by strong businesses. Some companies can look good with dividends yielding 5% or more before suffering an operational setback.
For example, we can find a lot of well-known names behaving in that manner among cyclical sectors such as finance, retail, mining, construction and others. Sometimes, dividends from these kinds of companies can be here today and gone tomorrow.
I tend to favour stocks backed with businesses operating in steady, defensive, cash-generating sectors such as pharmaceuticals, utilities, fast-moving consumer goods and others.
When it comes to reliable dividend streams, I think these kinds of stocks are hard to beat. I’m thinking of well-known names such as Tate & Lyle, SSE, Sage, Severn Trent, PZ Cussons, AstraZeneca, Britvic and many more.
However, even stocks like these can suffer their ups and downs. Just recently, some of my favourite names suffered something of a share price reversal. This includes defensive tobacco stocks, which are under pressure because of threatened regulatory changes to the industry from the USA.
There’s no escaping the risk involved with all types of stock investment. But with the additional risk, we often have enhanced potential for reward compared with other classes of assets such as cash savings.
How I’d use collective share vehicles
And one decent way of aiming to mitigate the risk is for me to invest in collective stock vehicles, such as investment trusts, trackers and funds run by a manager.
The great thing about these choices is my invested funds would achieve wide diversification across many underlying stocks. Such an approach can soften the danger of picking a duff investment, such as a cyclical company in the down stage of the business and economic cycle.
In one example of potential passive income from a collective fund, the FTSE 100 index has historically generated a dividend yield in excess of 4% a year. So if I assume a yield of 4%, I’d need around £150,000 in my Footsie tracker fund to provide a passive income of £500 a month.
But it’s a tall order to invest that much money straight away. And, luckily, I don’t need to. Over an investing career, I can compound regular monthly investments to build up my portfolio.
In the building stage, I’d roll all the dividends back into my investments to keep the compounding process going. And although no outcome is guaranteed, compounded gains can grow into a surprisingly larger sum.
I’d spread my monthly investment between several funds and carefully selected shares. And I’d keep investing for a long time. Then, when I need the passive income, I’d switch to collecting the dividends in my bank account.