Passive income plans come in all shapes and sizes. One I use is putting spare money into the shares of blue-chip companies with proven business models. Then sitting back and twiddling my thumbs while they pay me dividends.

Such an approach can also be lucrative, for those with some patience. Here is an example of how an investor with £20k could target an average passive income of £980 each month.

Letting dividends earn dividends

I say patience is important because the essence of this plan is not just earning dividends from that £20k, it is also then earning dividends from those dividends.

This approach is called compounding and it can be great at creating wealth, but it takes time to work. So imagine the investor put the £20k into shares yielding an average of 7.1%. After one year, that would produce £1,467 of dividends. Adding them to the investment, the second year’s haul should be £3,041. And so on…

Compounding like this for 30 years, the portfolio would be worth over £167,000. At a 7.1% yield, that would generate over £980 a month in dividends.

Smart principles of investing

I think 7.1% is achievable in today’s market, although it is well above the FTSE 100 average of around 3.6%.

Focussing only on yield can be dangerous though, as dividends are never guaranteed to last. So instead, I try to buy shares in great companies at attractive prices, only then considering the yield.

An investor should also follow other principles of good investing, such as reducing risk by diversifying. £20k is comfortably enough to split across five to 10 different companies.

One example to consider

When I say 7.1% is achievable, I have quite a few shares in mind. As an example, one FTSE 100 firm I think investors should consider is British American Tobacco (LSE: BATS). At the moment it offers a 7.1% yield.

The business is simple but highly profitable and cash generative. Cigarettes are cheap to make. But as they are addictive and British American owns a portfolio of premium brands, it has what is known as pricing power.

That has helped it push up prices and generate lots of cash to pay dividends even while cigarette sales volumes fall. I see declining cigarette smoking as a big risk for the firm over the next decade or two.

It could hurt the dividend prospects. British American does aim to keep growing its payout per share annually though, as it has done since the last century.

Choosing a way to invest

With the right approach and a long-term approach then, I think an investor could realistically target £980 of passive income each month from £20,000.

The first move today would be choosing a share-dealing account or Stocks and Shares ISA to use for the purpose.