I firmly believe that buying stocks and shares is one of the most straightforward ways to generate a passive income.
Indeed, unlike other passive income strategies, investors can buy dividend shares with just a few pounds. This could allow virtually anyone to start generating income with just a few clicks.
And this is the approach I would use to generate a passive income with an investment of just £500 a month starting today.
Passive income investments
Using dividend shares to generate a passive income can be a good strategy. However, dividend income is never guaranteed. This became painfully apparent last year when many companies had to scrap their dividend payouts as revenues plunged during the pandemic.
The risk of a dividend cut is always going to be present with income stocks. As such, this passive income strategy might not be suitable for all investors. Nevertheless, I’m comfortable with this uncertainty, which is why I’m happy to use the process.
I also think I can reduce the risk of being exposed to a dividend cut by using a fund. There are a couple of options investors can choose from when looking for income funds. These include the iShares UK Dividend UCITS ETF, the SPDR S&P UK Dividend Aristocrats UCITS ETF, and the WisdomTree UK Equity Income UCITS ETF.
All of these ETFs follow a slightly different investment strategy but have one overriding aim. That is to invest in a diversified portfolio of dividend stocks to produce a steady dividend income for their investors.
At the time of writing, the funds offer dividend yields of between 3% and 4%.
It all adds up
By investing £500 a month, I think I can use these funds to generate a passive income. A monthly deposit of £500 will yield a total pot of £6,000 after a year. A dividend yield of 4% could provide an annual passive income of £240.
That may not seem like much at first, but this income will compound with additional contributions providing a virtuous cycle. Of course, returns of 4% per annum indefinitely are by no means guaranteed, but over five years, even with no capital growth, this could produce a pot of £33.1k with an annual passive income of £1,324.
The one significant risk of using this strategy is the risk of a capital loss. Stocks can go up but also down, which is one of the biggest challenges of relying on income from dividends.
A sudden market decline could cause capital losses, which may exceed dividend income. In addition, if there are widespread dividend cuts in the market, the funds listed above may also have to reduce dividend distributions. These are the most significant risks and challenges investors following this passive income strategy face.
Still, I think this approach is a great way to generate income. That’s why I am using it myself, despite the risks outlined above.