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Buying stocks of tried and tested blue-chip companies is one way to earn passive income. It has worked for centuries, and while no company is guaranteed to pay passive income in the form of dividends, I am confident that building a diversified portfolio of high-quality blue-chip stocks should help me make money without working for it, for years or even decades.
To illustrate, let's say I have £20,000 to spare. Here's how I would use it to achieve an average of £300 of passive income per month.
Doing the math
It is fairly easy to calculate how much you can earn by owning certain stocks, with the caveat that what happened in the past may not be a guide to what you can expect in the future.
We use something called the dividend yield. The yield is basically how much I should earn per year in dividends as a percentage of what I invest.
So if I invest £20,000 at a yield of 7% (well above the FTSE 100 Index (an average, but I think it's an achievable number in today's market if we stick to blue-chip stocks), it should earn £1,400 per year in dividends.
A warning point and a game changer
As I said earlier, whether that happens will depend on what companies decide to do with their dividends.
Not all companies pay dividends. Among those that do, some keep them stable for many years in a row, others reduce them suddenly, and others increase them periodically. Therefore, investing in the right companies will be critical to the success of my passive income plan.
Still, £1,400 a year equates to a dividend income of about £116 a month – welcome unearned cash, but just over a third of my target.
So I would use a simple and revolutionary investment technique known as compounding. That means reinvesting my dividends so that I can buy more shares and hopefully earn more passive income in return. That way, after 14 years I should reach my monthly target of £300.
It is important to find the right stocks to buy, at the right price.
What types of stocks would you look for to build that diversified portfolio with its average yield of 7%?
An example of the type of stock I would consider is one I already have in my portfolio: Legal and general (LSE: LGEN).
The FTSE 100 financial services company operates in a market that will benefit from high customer demand over the long term. It can take advantage of this thanks to a number of competitive advantages, including an iconic brand, a broad customer base and deep expertise in financial markets. It has also taken steps in recent years to capture new, younger segments of the market, for example by emphasising the social credentials of some of its investments.
There are risks. Legal & General cut its dividend during the 2008 financial crisis. A weak economy could hit markets again, potentially hurting earnings.
Taking the first step
Still, with its 9% dividend yield, I think the share price reflects the risk. I consider the current price to be a good investment and will continue to hold the stock.
How would I get started with my passive income plan? My first step would be to deposit the £20,000 into a trading account or a stocks and shares ISA.
