I’d like to build a share portfolio that will provide a £10,000 passive income each year. This would double the current State Pension (£9,628). I think it would be a good start to my retirement planning.
Here, I’ll look at two methods for generating passive income from the stock market. I’ll then explain which one I’m using.
Option #1: FTSE 100 dividends
The easiest and safest way I know to generate a passive income from shares is to buy a FTSE 100 tracker fund. I’d probably choose the iShares FTSE 100 ETF with the ticker code ISF.
This is a distribution fund, which means that dividends received by the fund are paid out to investors.
According to research by stockbroker AJ Bell, the FTSE 100 has a forecast yield of 3.9% for 2022. I’d guess the yield received from the ISF fund might be slightly lower due to costs and tracking errors, so I’m going to estimate 3.8%.
To generate a £10,000 passive income each year from a yield of 3.8%, I’d need to invest around £263,000. One way to reduce the amount of capital required would be to generate a higher yield from my investment. Here’s how I’m doing this.
Option #2: Dividend shares
As an income investor, I spend a lot of my time looking for the best UK dividend shares. I’m confident I can select stocks that will generate a higher average yield than the FTSE 100.
My aim is to generate an average dividend yield of 5% from my portfolio. Right now, I’m slightly below this level, but I expect my yield to increase this year as several of my companies increase their dividend payouts.
If I can keep my portfolio yield at 5%, then I’d need to invest £200,000 to generate a £10,000 passive income. That’s £63,000 less than if I put the cash in a FTSE 100 tracker fund.
However, there are no free lunches in investing. My stock picking approach does carry some extra risks. If just one company in my portfolio runs into problems and cancels its dividend, my income could take a big hit. I could also face permanent losses from a share price collapse.
These risks are less likely to affect a FTSE 100 fund, where my investment would be spread across 100 stocks.
Passive income: what I’m buying
£200k is a lot of money. That’s why I’m aiming to build my fund gradually by investing in the best dividend growth stocks I can find. While I’m still working, I drip feed money into my Stocks and Shares ISA each month and reinvest all the dividends I receive.
By doing this, I expect to benefit from the power of compounding. This means earning dividends from my dividends. Compounding takes time to work. But after a while, returns can snowball.
For example, investing £100 per month for 10 years would create a fund worth around £17,000, based on a total return of 8% per year.
The same investment plan over 20 years would create a fund worth £55,000. That’s three times as much, in only double the time.
I can’t predict my future investment returns. But by focusing on good quality dividend shares I hope to outperform the FTSE 100 over the long term.