A 3-step passive income strategy to target major wealth

Investing in the stock market for passive income needs big brains and massive know-how, right? No, I say we can all do it if we follow some straightforward guidelines.

The stock market has beaten other investments for more than a century, and I don’t expect that to change.

Step 1: strategy

Dividend stocks pay passive income, right? Yes, they could be just what we want… once we’ve reached our goal and want to take the income. But until then, our aim is to build as much cash as we can. The bigger the pot the better, no matter how we get there.

An investor who put £10,000 into top US growth stock Nvidia five years ago could be sitting on £155,000 today without any meaningful dividends.

They could then transfer it to a dividend stock like City of London Investment Trust (LSE: CTY) and expect to add £6,800 per year to their income from its 4.4% dividend yield. The dividend, incidentally, has been lifted for 58 years in a row.

Or they could just sell some Nvidia shares each year.

There are two stages to generating passive income. One is building up the pot in the first place. The other is taking the income. They don’t both need the same strategy. We can choose what suits us best.

Step 2: diversification

Investors often make a key mistake when they start. They focus on a small handful of stocks, often in a sector they know. And they can face shocks if they fall.

Diversification is always important. But the pain of a single stock or single sector crash is more likely to put off a new investor. Those of us with more years under our belts should more readily accept the occasional bump.

We could split our cash as many ways as possible, and put each portion into a stock in a different sector. But we should take care not to pay too much in trading costs from too many small buys.

I prefer to start with an investment trust, like City of London that I mentioned above. That puts its shareholders’ cash into HSBC Holdings, BAE Systems, Shell, Tesco… some big names among its top 10 holdings, with wide diversification.

It’s still managed as a single company, so there’s some risk there. And if the 58-year run of dividend rises should falter, I could see a share price fall. But there’s no risk-free stock market investment — and definitely no guaranteed dividends.

Step 3: time

Finally, keep on buying, maintaining diversification within our chosen strategy. Invest as much as we can for as long as we can.

Using City of London as an example, I’ll assume a consistent 4.4% dividend yield, plus 2% per year for share price growth — just guesswork, but I think reasonable.

An ISA allowance each year for 10 years could turn the total £200,000 invested into £315,000 for a 49% gain. Do it for 20 years and £400,000 could more than double to £863,000. Or 30 years could see £600,000 treble to £1.88m. Of course, that’s not guaranteed and returns can fall as well as rise.

We don’t all have that much money to invest. But whatever we have, the multiplication factor will be the same. And look at the difference the extra time makes.