Here’s my 5 step approach to earning £500 a month in passive income.

Passive income can be elusive. In theory, all sorts of ideas on how to make money without working seem attractive. In practice, some work better than others (and some don’t work at all!)

One proven way to generate passive income is to buy a diversified selection of shares of proven dividend-paying companies. Since dividends will never last, spreading your money across multiple stocks helps manage this risk.

Here’s the five-step approach I use to do this!

1. Willingness to buy shares

It can be frustrating to discover a large share to buy but not be able to do so. This way, I get things organized ahead of time by setting up a way to buy stocks.

This could be, for example, a shares trading account, a stocks and shares ISA, a self-invested personal pension (SIPP) or a combination of these.

2. Studying the stock market

A good company may not be a good investment. For example, perhaps a business makes a lot of profit but has so much debt that it has to use it all to pay off its creditors. Or maybe the stock price is simply too high.

So before I invest (and on an ongoing basis), I take the time to learn how the market actually works. This learning process never stops.

3. Search for stocks to buy

My next step is to look for stocks to buy. To illustrate, consider one I purchased this month. JD Weatherspoon (LFB: JDW).

Demand for pubs and hotels (Spoons operates both) is strong. This could change as the number of pubs declines and I see this as a risk to overall consumer demand.

But I think it could be good for Spoons. As a low-cost operator with a proven business model, it could take business away from weaker competitors. The cost structure is also threatened by significant tax hikes in the recent budget. Indeed, this caused the publican’s stock price to fall, and that’s when I bought some shares.

I expect that over time the company will be able to offer its customers higher prices for raw materials. Large assets, a proven operating model, a competitive cost structure and economies of scale all help me view the share price as a bargain.

4. Receipt and (possibly) reinvestment of dividends

However, given the dividend yield of 2%, I expect to earn just two pence a year for every pound I invest in Spoons shares at the current price.

Without changing my investment principles, I strive for a higher average return on my portfolio. Reinvesting dividends initially can also help me build a larger portfolio without increasing my own regular contributions.

For example, if I invest £200 a month in shares with an average return of 5% and multiply the dividends, after 26 years I will have an average monthly passive income of over £500.

5. Stay involved

I could have started earning sooner if I had just accepted the dividends as cash instead of reinvesting them. My approach is to not keep fiddling with the portfolio. I am a long-term investor, not a trader.

But not only do I earn passive income, but I will also keep an eye on its source in case the investment case for any stock I own changes in the future.