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The desire for passive income is a common goal for many people. That’s probably even more so nowadays, given the sharp rise in the UK’s cost of living.
I found an old shopping bill the other day in my car boot. It was from three years ago and showed I spent £76. As an experiment, I decided to visit the same store and buy the exact same items. Unfortunately, there were a couple of things that weren’t available, so I bought similar. The bill came to nearly £120!
Thankfully, inflation finally appears to be easing now and interest rates are tipped to fall. But this period has sharpened my focus to find stocks that generate an attractive real return (ie above inflation).
At least there’s still the ISA
Britons may be facing higher prices, but we’re fortunate to have the Stocks and Shares ISA. This investment vehicle shields any capital gains and dividend income from tax.
This means I can invest up to £20,000 a year and not have to worry about tax. So if I had a spare £7,000 to invest today, I’d move the money straight into a Stocks and Shares ISA.
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.
Lots of choices
A solid passive income portfolio will typically possess a diversified mix of growth stocks and high-yield
dividend shares. The former will probably have lower yields as the businesses continue to invest in growth opportunities, while the latter will prioritise dividends for shareholders.
High-yield income shares I like include asset manager M&G (9.5% yield), Asia-focused banking giant HSBC (7.1%), and insurers Legal & General (9%) and Aviva (7%).
An example of a quality dividend growth stock from my portfolio is Games Workshop (LSE: GAW). The company owns Warhammer 40,000, the miniature tabletop wargame that has millions of dedicated fans around the world.
The FTSE 250 stock only yields 2.7%, but the company has a policy of distributing surplus capital in the form of special dividends. Pair these with the 168% share price rise over the past five years and investors have had a market-thrashing investment on their hands.
But why has the stock been a smash hit? Well, the market tends to reward firms with incredibly high returns on capital and fat profit margins. Games Workshop has both.
Generating income
Naturally, it isn’t nailed on to maintain this form indefinitely. Dividends may be cut if earnings come in light because, say, a new product range disappoints customers. That might lead investors to question the stock’s premium earnings multiple, which currently stands at 26.
This is why I’d build a basket of stocks with my £7,000. Doing so, I believe it’s realistic to aim for a 10% return over time through an average 6% yield and 4% price appreciation.
With this average, a £7k investment would grow to £47,092 in 20 years, paying £2,825 a year in dividends.
However, investing an extra £250 each month from the start would juice my portfolio to £226,792, with annual dividends of £13,607. I’d keep reinvesting those payouts to fuel compounding returns.
After 30 years, my ISA would reach £638,245, generating dividends of £38,294 a year — almost £3,200 a month.
Whatever inflation looks like at that point, I’m sure this passive income would significantly improve my living standards.
