Investing in the shares of companies listed on the FTSE 100 has proven to be an ideal way to start generating passive income. Over time, this can eventually deliver me a second income of £10,000 or more.
Admittedly, it’s more difficult to save money to invest at the moment due to the rise in the cost of living. And winter is on the way, with our homes needing to be heated, which certainly isn’t cheap nowadays.
But if I want to build a substantial passive income stream, then I’m going to have to put my money to work somewhere. Here’s how I’d do this by building a portfolio of high-quality Footsie stocks.
Spending less than I earn
Unfortunately, the concept of living frugally sometimes attracts a bad reputation. That’s because it often gets conflated with living a Spartan existence devoid of any creature comforts.
But in my eyes, it simply means living within my means. I can still enjoy occasional luxuries.
More specifically, though, it means spending less than I earn so that I can put together a monthly savings amount, whether that’s £500, £1,000, or more.
For me, I think an amount between those two figures — say £750 — is realistic and could be a useful milestone to aim for.
Saving £750 each month would mean being able to invest £9,000 annually.
Choosing solid FTSE 100 shares
There are many high-quality FTSE 100 stocks I can choose from today. But I’d start with world-class companies that have a long history of growing their dividends and underlying value.
One good example here would be BAE Systems (LSE: BA.). As the world sadly becomes more unstable with multiple wars, governments are upping their military budgets. And many are increasingly turning to large defence contractors like BAE.
The company’s order backlog stood at a record £66.2bn at the end of June. That was before the Middle East erupted into conflict again.
While BAE has increased its dividend payout for decades, it currently only yields 2.5%.
However, it’s important to remember that this is a starting dividend yield. If the company can keep growing its earnings and payouts, then the yield relative to what I paid for my shares could grow from 2.5% to 3%, then 3.5%, 4%, and so on.
Additionally, I’d invest in some high-yield dividend shares to build out a diversified portfolio. This is crucial to minimise the impact of unexpected dividend cuts and share price declines.
BAE shares could fall if, for example, investors start to worry that the elevated level of military spending isn’t sustainable.
How quickly could I get to £10k in passive income?
Now, let’s assume I put £750 a month into FTSE 100 shares, reinvested my dividends, and achieved an average return of 7% a year. That return isn’t guaranteed, of course, but it’s the ballpark long-term average for the Footsie.
In this scenario, due to the power of compounding, my portfolio would reach a value of about £146,600 after 11 years.
If I then switched entirely to dividend stocks collectively yielding 7%, I’d have reached my £10,500 a year passive income target. The same principle of diversification would still apply though, with my portfolio invested in a wide range of companies to reduce the chance of underperformance.
The post How I’d build £10,500 of annual passive income from scratch with FTSE 100 shares appeared first on The Motley Fool UK.
Ben McPoland has positions in BAE Systems. The Motley Fool UK has recommended BAE Systems. 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