£12,000 of savings? Here’s how I’d try and turn that into £547 a month of passive income

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Making money while we sleep remains the pinnacle of the passive income investment idea. And if we do not find a way of doing this, we will work until we die, as legendary investor Warren Buffett said.

The best way I have found to achieve this goal is to invest in high-quality shares that pay high dividends. There are several to choose from in the FTSE 100.

Three of my current favourites are Phoenix Group Holdings (yielding 10.7%), M&G (9.6%), and Legal & General (8.5%).

In my 35 years of experience in the investment world, three other factors are key to maximising returns.

The first is to start as young as possible. The second is to reinvest all dividends received back into high-yielding shares. And the third is to invest as much as can be afforded.

Saving for investment

The average UK salary is £26,736 after tax and other deductions. And an often-used method for managing personal finances is the ‘50/30/20’ rule. This splits the distribution of personal income into expenditure across three categories.

‘Needs’ (including groceries and housing costs) should account for 50% of income spent. ‘Wants’ (including restaurant meals and holidays) should comprise 30%, and ‘Savings’ (including investments) should see 20% earmarked for it.

I would use all the ‘Savings’ category for investment in high-quality, high-yield stocks. I would also reduce as much of my ‘Wants’ as possible, so that I could save £1,000 a month minimum.

If I did this for just one year, I would have a starting investment pot of at least £12,000.

Choosing the stocks

Aside from being in a well-regulated index and paying high dividends, a stock must have two other qualities for me.

First, it must be undervalued compared to its peers, otherwise my dividend payments might be wiped out by share price losses.

Second, the core business must look poised for sustainable growth. To ascertain whether it is, I look at key financial ratios, new business initiatives, and senior management capabilities, among others.

Dividend growth compounding

Like Warren Buffett, I use the dividends a company pays me to buy more of the stock. This means the size of my holdings in each high-yielding share selected continues to grow, paying more dividends over time.

It is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.

As an example, the three-stock high-yield portfolio above currently has an average yield of 9.6%.

£12,000 invested today would produce a total investment pot of £75,057 after 20 years. It would pay a yield of £6,574 a year – or £547 a month. This is provided that the yield averaged the same over the period, which it may not. It also includes no further monthly investments.

However, if I also continued to invest £1,000 a month, then I would reach the same-sized pot would after around four years. And after just 10 years, it could total £233,040, paying £20,740 a year in dividends – or £1,728 a month.

These figures assume no change in the average yield, of course. Inflation would also reduce the buying power of the income. And there would be tax implications according to individual circumstances.

Our analysis has uncovered an incredible value play!

This seems ridiculous, but we almost never see shares looking this cheap. Yet this recent ‘Best Buy Now’ has a price/book ratio of 0.51. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 51p they invest!

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See the full investment case

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Simon Watkins has positions in Legal & General Group Plc, M&g Plc, and Phoenix Group Plc. The Motley Fool UK has recommended M&g Plc. 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.