Passive income is money that one receives without working for it. That might sound unbelievable, but it happens all the time. Rental fees, royalty payments, and share dividends are all examples of passive income streams. One might not have the money to buy a property to rent out, or have the talent to write music that could generate royalties. But investing money into high income shares is a way to generate passive income even with a relatively small amount of money to start.
Diversification helps reduce risk
£3,000 is enough to invest in more than one share. In fact, it is enough to invest £1,000 in each of three different companies. I prefer that approach as it diversifies my portfolio. That helps reduce risk, in case one of the companies cuts their dividend or meets some unforeseen challenges in its market. But diversification can also help when it comes to timing passive income.
Different companies pay out dividends on different schedules. If I invested £3,000 in one share, I’d only get the income when it paid out its dividend. By investing in different shares, I could get income at different times from the various companies. Some companies pay dividends four times a year. If I invested in three different companies each paying their four quarterly dividends in different months, I could even end up receiving some passive income every month.
Higher dividends are good for passive income
With passive income as my investment objective, I wouldn’t pick shares that don’t pay out dividends. That actually rules out a lot of fast-growing shares such as S4 Capital and The Hut Group. That’s because companies that are growing fast often prefer to reinvest spare cash into the business to fuel further growth. Companies that pay out a high percentage of their earnings as dividends are often in more mature industries, such as mining or consumer goods. They often see marginal returns into ploughing more cash back into long-established businesses, so they pay out spare cash to shareholders as dividends.
I would start by looking at a list of the highest yielding shares. Yield is more important to me than the absolute dividend size. The yield is the percentage of my capital I would expect each year as income. It’s similar that way to an interest rate. By contrast, a dividend that looks high might not make me much passive income if the shares are also highly priced, pushing its yield down.
Then I’d look to see how sustainable the dividends looked. For example, does the company generate enough cash to cover it and will that continue to be the case? Business can meet unexpected difficulties, so there is always a risk dividends can be cut. But I prefer investing in companies that are highly cash generative and are set to continue that way, like Unilever or British American Tobacco.
I’d also look at the dividend history, to see whether the company has a history of increasing its dividend. British American Tobacco has raised its dividend annually for a couple of decades. That might not continue, but if it does, it could be an agreeable source of passive income.
