Passive income is, in many ways, the key to financial independence. Warren Buffett famously said that “If you don’t work out a way to make money while you sleep, you’ll work till you die.” To someone with no savings this may seem an impossible task. But it’s not. Here’s how I’m building a passive income portfolio with only £100 pounds a month.
Dividend investing is one of the most popular ways to build passive income.
Dividends are payments taken from the company’s profits and given to shareholders. I love dividend payments because, unlike share price growth, this is cold hard cash which I can re-invest, creating a compounding feedback loop. Starting off with only £100 a month may not seem like much, but some companies, such as Imperial Brands, consistently pay more than 20p per share to their shareholders, multiple times a year. Just remember, a dividend payment can go up and down and there is no guarantee that the yield will be the same each year, or even made at all.
A dividend yield is a percentage representing the amount paid by a company over the year as it relates to its share price. For example, if a company pays a 50p dividend and its shares are worth £5.00 then the yield is 10%. It just so happens that many dividend yields are at all-time highs right now, so it’s not uncommon to see companies paying 10% or even 15%.
However, these high rates are very expensive for a company and can affect its ability to grow as a business over the long term. I personally would rather take a smaller average yield with a company that has a strong, growing business. Lloyds Bank has rewarded shareholders with an average of 3% over the last five years, with one special payment reaching 10%. In that time, the Lloyds share price remained relatively consistent, fluctuating mostly between the 50p and 70p before the Covid crash.
It’s very tempting to balance out my portfolio with high-yield dividend companies. EVRAZ, a British mining company, paid 13% in 2017, 12% in 2018, nearly 14% in 2019, and 9.5% in 2020. Who wouldn’t want returns like that? But these high percentages can actually be misleading. EVRAZ’s share price fell 64% between June 2019 and March 2020, meaning that the actual amount paid to investors fell significantly.
A high yield isn’t always a bad sign, but it can indicate trouble with the business.
What’s great about this strategy is flexibility. When I have a lump sum, it can be tempting to invest it all at once. But no one knows what will happen in the stock market. It could shoot up or it could all crash tomorrow. Limiting myself to £100 a month means I am more able to adapt to those changes and take advantage of opportunities as they appear. And all the while, the portfolio I’m building will pay me increasingly larger amounts with which I can invest. It may not make me a millionaire, but by the time I retire I could have a significant nest egg supplementing my pension.
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James Reynolds has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands and Lloyds Banking Group. 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.