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Buying stocks for passive income has worked for millions of people for centuries.
It doesn't always work: Dividends are never guaranteed, so it's important to choose carefully.
But if I take the time and research to try to buy great companies when their shares offer a good price and good income prospects, I think I could aim to generate substantial streams of long-term passive income even from relatively modest contributions.
If I had an extra £200 a month to put into this plan, here's how I'd aim for an annual passive income of £7,100 over the long term.
Buy stocks that generate unearned income
Finding the right type of stock is critical to this plan. I want to buy companies that I think could generate significant excess income that they could use to fund dividends in the future.
Although my focus is on income, I also want to make sure I don't pay too much for the stock, otherwise I risk ending up selling the stock at some point in the future for less than what I paid for it, even if I received dividends. . along the way.
Even the seemingly best action can disappoint. Then I would diversify my portfolio into different companies.
A stock to consider buying now
As an example of the type of stock I think investors (including new ones) should consider buying to try to establish a long-term passive income stream, consider one I own: Diageo (LSE: DGE).
The firm owns a large number of premium beverage brands, from Johnnie Walker to Smirnoff. The alcoholic beverage market is big and I hope it stays that way. Owning premium brands gives Diageo pricing power. That helps you generate significant free cash flows. That has allowed it to increase the dividend annually for more than three decades.
Will that continue? Younger consumers are drinking less alcohol now than previous generations and Diageo has been grappling with how to address falling demand in Latin America specifically.
But looking at the bigger picture, I'm optimistic about the long-term dividend prospects of owning the stock.
Dividends can add up!
Currently, Diageo's dividend yield is 3.1%. So for every £100 I invest today, I expect to earn around £3.10 in dividends annually if the payout per share stays where it is now.
In today's market, you could aim for a higher average yield (say, 7%) while still holding blue-chip stocks in proven businesses.
If you invested £200 a month and reinvested the dividends along the way (a very powerful move known as compounding), with an average return of 7%, you would be earning over £7,100 in dividends after 20 years.
I would take the first step now!
That plan seems realistic, affordable and potentially very lucrative to me.
Whether it's £200 a month or so, my first step would be immediate, now. I would set up a shares trading account or stocks and Shares ISA and set my regular monthly contributions.
