I first started investing in an attempt to become richer. I couldn’t exactly define what ‘richer’ meant at the time. Essentially, I knew I wanted to earn more than my annual salary. This is where passive income comes in. Once I began investing and buying quality stocks, the dividends started rolling. My portfolio value was also increasing over time so it was a win-win.
I’ve refined my investing strategy over the years from when I first started to invest. Here’s how I would start generating passive income today using what I’ve learnt.
Assets that generate passive income
The most important rule I’d follow is to buy productive assets. An asset is something I own that will generate cash flow for me in the future. I didn’t fully realise at the start, but this is exactly what I was doing when I bought stocks. If I buy shares of a company that pays a dividend, I should earn income from my investment in the future. It’s a great example of a cash-producing asset.
There are other assets I could consider. Bonds pay interest, which is another example of an asset that generates cash. Interest rates are historically very low right now though. A 10-year UK government bond only pays about 1.2% annually, so I’ve avoided buying bonds over the years. However, there’s a benefit to investing in government bonds as they’re typically less risky. For example, the UK government is almost guaranteed to pay the 1.2% interest each year, so it’s considered ‘safer’ than a dividend stock. The ‘reward’ (the interest rate) is lower, but the risk is also lower.
In addition to buying productive assets, the second most important thing I’d do is reinvest the passive income I earn. And I would reinvest any income in an ISA so it’s tax free. If I do this, then I will benefit from compounding over the years. Basically, my passive income should get bigger and bigger with time.
Dividend stocks
Now I want to explore my favoured productive assets: dividend stocks. I aim to buy shares of companies that pay out earnings to shareholders like myself. If the business does well, I will get a cut of the profits.
Luckily for me, the FTSE 100 is a great place to hunt for dividend stocks. I would buy shares of Legal & General and Aviva first, two companies in the financial services sector that have paid dependable dividends over the years.
I’d also diversify my portfolio in the mining sector. Rio Tinto and BHP Group both pay a high dividend yield today. I’d also buy National Grid. It operates in the defensive utilities sector, so it should carry on paying a respectable dividend going forward.
All of these companies have generated an average 10-year dividend yield greater than 5%.
The tricky thing with dividends is that they’re never guaranteed. I could buy these companies in my ISA today, only to find out that the dividends are being cut if earnings fall.
Final thoughts
The most important thing I’ve learnt over the years is to be patient with my investments. Investing always comes with risks, so I need to take a long-term view. But today, I aim to buy productive assets in my ISA. Dividend stocks offer me the greatest balance of risk-to-reward to generate passive income.
Dan Appleby owns shares of Legal & General, Aviva, Rio Tinto and BHP.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. Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
