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Passive income is money that you earn without having to work for it.
Some people try to earn passive income by setting up an online business or buying a property to let. Another idea, that can be done from a standing start on a small budget, is buying shares in proven blue-chip companies that one hopes will pay dividends in future.
That need not take a lot of money. Here is how I will try to build income streams next year (and far beyond) for just £3 a day.
Regular saving can add up
£3 might not sound like a lot. Indeed, many people might not even notice much if they had £3 less each day in their purse or wallet.
But over time, such small seeds can grow into sizeable financial results.
Saving that much for a year would give an investor £1,085 to invest. So, over a decade, it would mean that investor had over £10k to put to work in the stock market.
But that is only the beginning.
To earn passive income, remember, I want to buy shares that pay me dividends. I could hopefully grow my income streams from there by reinvesting those dividends, a simple but powerful stock market method known as compounding.
Compounding as a way to build income streams
Let me illustrate.
Say an investor invests their money at an average dividend yield of 7%, meaning that for each £100 they put in, they ought to earn £7 per year in dividends.
If that investor keeps compounding for a decade, sticking to the £3 a day contribution level, then 10 years from now their portfolio would be worth just shy of £15,800.
If they then stopped compounding and started drawing the 7% yield as cash, their passive income would be around £1,100 per year.
Finding shares to buy
Next year, I will be looking for great companies with attractive share prices that I think could generate enough excess cash to fund chunky dividends.
One example of such a share, that I bought this year, is Legal & General (LSE: LGEN).
The FTSE 100 company is a well-known name with an iconic multi-coloured umbrella logo. I see that sort of brand identity as an asset, as it helps Legal & General attract and retain customers. By operating in the huge market of retirement-linked financial services, the firm can use such competitive advantages to put clear water between itself and rivals.
That is good for its pricing power, which in turns fuel profits. The business is a strong cash generator and its current yield is 9.3%.
If markets plummet and policyholders pull out funds, profits could collapse and I see a risk Legal & General might cut its dividend, as it did during the 2008 financial crisis.
Getting started for the long run
Legal & General’s yield is well above the FTSE 100 average of 3.6%.
But if I can buy quality shares yielding an average of 7% and reinvest the dividends, after a decade my portfolio ought to be throwing off passive income of £767 annually.
Where do I put the £3 a day to get going? I will use a share-dealing account, Stocks and Shares ISA, or my SIPP.
