How I’d try to build a passive income with just £25 a week

I currently receive some passive income and it comes from carefully selected dividend shares. Here’s how I’d set up a new income stream if I were to start today. The first thing I’d note is that I can start with almost any amount. In my illustration, I’m planning to invest just £25 a week, so roughly £108 per month.

Long-term investing

In my opinion, one of the most important components of successful investing is time. The longer I have before needing to withdraw any income, the further my investment can grow. The long-term average stock market return is roughly 10% a year.

A word of warning, though. That is just an average, and it’s by no means guaranteed. There have been many years when the average return has been much higher, and years where it has been lower or even negative. But having a longer time frame allows me to smooth out my returns, and hopefully, at least achieve the average return.

Growing the pot

Let’s say I can save £25 a week consistently for 20 years. If I achieve the long-term average return of 10% per year and leave my returns to accumulate, I’d have a pot worth around £82,000. That’s over triple my initial outlay. I like the sound of that. However, I’d try to achieve a much greater return by carefully researching and selecting quality growth shares. I’d want to invest in faster-growing companies, particularly in the earlier years of my investment plan. I’d also select a broad basket of small-cap, mid-cap and large-cap UK and US shares. I reckon small and mid-sized companies could grow faster. And the larger companies might help my portfolio to be less volatile. Alternatively, I’d pick a few growth funds or investment trusts. Currently, I like Smithson Investment Trust and Scottish Mortgage Investment Trust.

Generating passive income

If by active selection I manage to achieve an average gain of 15% per year instead, after 20 years my pot could amount to £162,000. But how much passive income could this pot generate when I start to draw an income? Well, the average FTSE 100 dividend yield is currently 3.4%. That would give me an annual income of £5,546. However, I reckon I can find several dividend shares that distribute 6%-7% every year. Currently, I like the look of Persimmon, Rio Tinto and Vodafone.

That said, dividend yields aren’t guaranteed either. Companies can increase, decrease and even suspend payments. For example, in March 2020 several companies suspended dividend payouts due to the pandemic.

Even so, I’d say it’s important for me to find companies that are consistent and reliable dividend-payers. I’d want these businesses to have a long history of paying dividends. I’d also want these companies to be able to comfortably afford them. Lastly, I’d like to see evidence of growing earnings. If earnings can grow, I’d be more confident that my dividends might increase too.

Going back to my example, at a 6% dividend yield, my pot could generate a passive income of £9,720 every year. To me, that’s pretty good for having only invested £25 a week. But again, it’s dependendent on my investments having generated well above 6% returns for the first 20 years.

Harshil Patel owns shares of Persimmon and Scottish Mortgage Inv Trust. 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. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.