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Could I invest £20,000 in FTSE 100 shares to target a £3,000 passive income?

Young female couple boarding their plane at the airport to go on holiday.
Young female couple boarding their plane at the airport to go on holiday.

Putting money into businesses today in the hope of generating strong future returns is what long-term investing is all about. That is one of the approaches I take with my Stocks and Shares ISA, for example. With some FTSE 100 shares currently offering juicy dividend yields, I have been thinking about how I might generate future returns by investing today.

Here is how I would invest £20,000 now if I wanted to target £3,000 of annual passive income in years to come.

Focus on quality

How much I can expect to earn in dividends if companies maintain their current payouts depends on the yield of the shares I buy?

For £20,000 to generate £3,000 in annual dividends from year one, I would need to earn a 15% yield. That sort of yield is not unheard of among FTSE 100 shares, but it is unusual.

For example, FTSE 100 member Persimmon currently has a 17.5% yield. But Persimmon announced this week that it is reviewing its dividend policy and does not plan to pay a special dividend this year.

Instead of starting with yield, I always first look for quality businesses trading at attractive prices. Only then do I consider dividend yield.

The power of compounding

That approach has led me to own FTSE 100 shares such as British American Tobacco with its 6.6% yield and 9.9% yielding M&G.

To manage my risk, I always diversify my portfolio. So I would spread the £20,000 across a number of FTSE 100 shares. Imagine that I could average a yield of around 8.5%, roughly the midpoint of the British American and M&G yields. Investing £20,000 at an average 8.5% yield should hopefully earn me around £1,700 per year in dividends. That would certainly be a welcome boost to my passive income – but it is far from my ultimate target of £3,000.

All is not lost, however.

Instead of taking out the dividends as cash, I could reinvest them. This is known as compounding. Basically that means that my dividends could themselves be invested in shares that start to earn dividends. At an average yield of 8.5%, after seven years my portfolio should be worth over £36,000. That would generate just over £3,000 in annual passive income.

Income from FTSE 100 shares

The above example presumes constant share prices and dividend yields. In reality, they could move around. That might make it harder for me to hit my target – but it could also help me get there faster. Both M&G and British American Tobacco have raised their dividends this year.

If I focus on finding high-quality FTSE 100 shares at the right price, I hope the power of compounding can help me turn £20,000 today into £3,000 per year in passive income. That would require patience as I may not hit my target for seven years. But as a long-term investor, I do not mind waiting to reap my reward.

The post Could I invest £20,000 in FTSE 100 shares to target a £3,000 passive income? appeared first on The Motley Fool UK.

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C Ruane has positions in British American Tobacco and M&G PLC. The Motley Fool UK has recommended British American Tobacco. 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 2022