It is possible to make a passive income stream from shares. The trick is to be patient and start buying shares as soon as possible.
When you’ve started your portfolio, to make the most of compound interest, it’s essential to reinvest all your dividends for long-term growth.
By following this approach, I think you could turn a small sum, such as £100 a week, into a sizeable financial nest egg.
Passive income stream
The first stage in building a passive income stream is to accumulate a savings pot to invest.
The amount you need to save will depend on how much income you want to generate. Some investors might be happy with a small passive income stream to cover housing costs. Other investors might want a more considerable monthly passive income.
For this article, I’m going to propose a passive income stream of £500 a month. To hit this level of income, my figures suggest an investor would need to put away somewhere in the region of £150k to £200k.
Building the pot
I think it could be easy to hit this target with just £100 a week.
You see, since its inception around 35 years ago, the FTSE 100 has produced an average annual return of 8% for investors. At this rate of return, I calculate it would take 18 years of saving to build a £200k nest-egg.
There are several approaches investors can use to achieve this sort of return. The easiest way is to buy a low-cost FTSE 100 tracker fund. This would provide investors with a diversified basket of UK stocks at the click of a button. It would also provide a passive income stream of 3.6% per year — the index’s current dividend yield.
Another approach is to use a basket of high-quality blue-chip stocks. Some investors may prefer this approach because you may be able to achieve a higher return on your money.
For example, the FTSE 100’s average dividend yield is currently 3.6%, but some stocks, such as Phoenix Group, yield more than 6%.
At this higher rate of return, an investor would need to put away just £100,000 to earn a passive income stream of £500 a month for £6,000 a year.
Another example of a company that supports a market-beating dividend yield is Direct Line. Shares in this insurance giant currently provide investors with a dividend yield of 9.4%.
Reinvesting dividends is an essential part of an income plan. When dividend income is reinvested, investors pick up more stock, which then produces its own dividend income. This endless virtuous circle can help anyone build a passive income stream with no effort.
As such, all I need to do to build a passive income stream is make sure I’m putting away my £100 every week. From there, I rely on the magic formula of compound growth and interest to build my income stream.
Rupert Hargreaves has no position in any of the shares mentioned. 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.