Investing in the stock market is a time-honoured way of generating passive income. My own preference is to reinvest the dividends I receive back into buying even more shares, holding them for the very long term.
Doing this, I’m benefitting from compound returns, which is arguably the ‘secret sauce’ in the wealth-building process. Even the equivalent of £20 a day is enough to get the ball rolling.
Over time, the cumulative effect of my invested savings could one day create passive income of more than £43,000. Here’s how.
Taking advantage of cheap UK dividend shares
Saving £15 a day equates to just over £608 a month. If I open a Stocks and Shares ISA where dealing charges aren’t applied to each trade, that would work out at £7,300 a year.
So, where would I invest right now?
Personally, I’d start searching the FTSE 100 for stocks, as the index is currently trading at a large discount to its historic average. Indeed, its trailing price-to-earnings (P/E) ratio is 10.9.
For context, the Footsie has traded at an average trailing P/E of 14.9 times over the last five years and 16.3 times over the past decade.
So the index appears significantly undervalued. And as Warren Buffett has said: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down“.
In particular, I find financial stocks very attractive right now, especially in the insurance sector. For example, Legal & General and Aviva are trading with respective dividend yields of 8.58% and 8.1%.
Both payouts appear to be reasonably well covered by earnings, though companies do cut or even cancel their dividends occasionally. A dividend cut is an occupational hazard for an income investor.
Going for share price growth
Now, the Achilles heel of the London Stock Exchange is arguably its lack of tech stocks. These businesses often scale rapidly as their digital services and products can be rolled out quickly.
Unfortunately, just 1% of the FTSE 100 today is made up of tech stocks. So my go-to choice here would be Scottish Mortgage Investment Trust, which is invested in dozens of high-growth businesses.
Right now, the trust’s shares are trading at a 17.7% discount to the underlying value of its assets. In essence, that’s like buying £1 coins for around 83p!
Combining both these strategies — high-yield dividend stocks and growth investing — I’d hope to achieve an average 9% annual return. That’s not guaranteed, of course, but it is around the long-term annual average of the UK and US markets combined (with dividends reinvested).
£43k of annual passive income
So how much would I end up after 25 years of investing £20 a day?
The answer is an incredible figure of £618,316.
Again, that’s with a 9% average return and reinvesting my dividends in order to buy more shares.
After 25 years, I could switch to spending the cash generated from dividend stocks in my portfolio. With a 7% yield, I would be earning £43,280 a year in passive income.
That’s the sort of annual income that could help fund an early retirement! All from saving £20 a day to invest in the stock market.
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Ben McPoland has positions in Legal & General Group Plc and Scottish Mortgage Investment Trust Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2023
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