There are numerous ways of building a passive income, from starting a business to flipping houses. Yet most of these methods require a tremendous amount of effort and money.
Comparatively, buying shares in dividend-paying stocks doesn’t have these barriers to entry. And with as little as £100 a month, a fairly substantial stream of passive income can be generated over the long term.
Let’s explore how and the risks involved.
Building passive income with dividends
When a business has excess capital with no immediate need for it, the money is often returned to shareholders through a dividend. Investors receive a cheque proportionate to the size of their investment. In other words, the more shares I own, the more money I will receive.
With no involvement in the day-to-day operations of the underlying business, I can start making passive income by simply owning shares. That’s why dividends are often described as the easiest option to make money while sleeping.
However, I first need to buy some shares. And unlike some individuals out there, I don’t have vast sums of wealth just sitting in a bank account. Fortunately, this hurdle can be overcome by saving a small amount each month.
If I set aside £100 a month, that’s £1,200 per year. On average, the FTSE 100 yields around 4% in dividends a year. But there are plenty of companies which offer more. And by being selective, achieving a yield of 6% is very do-able. That means after one year, my passive income stream is a grand total of £72… that’s hardly anything to get excited over. Or is it?
Suppose I re-invest these dividends and continue to contribute £100 a month over the long term? In that case, the payout can reach substantial proportions. Thanks to the beauty of compounding, after 10 years, that £72 becomes £4,252. And if I keep going for 30 years to retirement, this £4,252 transforms into a whopping £61,479!
Too good to be true?
The idea of seeing 60 grand magically appear in my bank account for doing nothing beyond buying and holding some shares can seem a bit unrealistic. And there are reasons to be sceptical since investing is not a risk-free endeavour.
Firstly, dividends are optional for a business. Not all stocks return capital to shareholders like this. And in times of crisis, like the pandemic, for example, dividends are usually one of the first expenses on the chopping block. It’s entirely possible to buy shares in a company, only for it to later announce the dividends are being cut, or outright cancelled.
Something else to consider is the actual share price. Even if dividends remain intact, the same may not be true for the value of the stocks in my passive income portfolio, potentially wiping out my returns.
The bottom line
Despite these valid concerns, I feel it’s a risk worth taking, especially since they can largely be mitigated through diversification. And in my experience, by investing only in the companies that generate plenty of cash flow and have little debt, the odds of an adverse change in dividend policy is less likely to occur.
