Many people talk about the idea of earning money without having to work for it. But how can one turn that idea into a reality? One way I do it is by investing in dividend shares. Here, in seven steps, is a passive income plan I would consider using with the aim of earning £500 a month.
Step one: clarify my objectives
People have different reasons for wanting passive income. I think it would be worth figuring out exactly what I want and designing my plan around it.
For example, the amount of passive income I get from dividend shares depends on two things – how much money I invest and the average dividend yield of the shares I buy. So to try and hit a monthly target of £500 — or £100 or £1,000 — will likely involve me putting a different amount of money into bringing my plan to life. Knowing what I am aiming to do and on what timeline can help me optimise the plan for my own needs.
Step two: start saving
The source of passive income in my plan is dividends from shares. To get them, I will need to spend money buying shares. So my plan requires money.
One approach would be to put the money in upfront. If I want £500 a month in passive income and buy shares with an average yield of 5%, I will need to invest £120,000.
A second approach would be to invest month by month. That would mean I took longer to hit my target of £500 each month. But it could be a good approach if I do not have much money at the moment and want to build up my investments over time.
I think the key to such an approach is discipline. I would seek to set a monthly target and stick to it. That would hopefully be habit forming.
Step three: learn about stocks and shares
How could I decide what the best shares would be for me to buy as part of my passive income plan? I could read lots, speak to people and watch videos. But what is right for other investors will not necessarily be best for me, either in terms of my investment objectives or risk tolerance.
That is why I would start to learn more for myself about how shares work. For example, what is the source of a company’s dividend? How can I tell if a company is likely to change its dividend in future? Does it matter to me if a company keeps paying the same dividend but its share price declines over time?
Learning about these matters does not have to be difficult, but I think it is very important. Hopefully it can help me avoid “yield traps” where investors buy a share with a high dividend yield only to see the dividend cut down the road.
Step four: make a shortlist of dividend shares to buy
As my regular contributions started to add up, I would begin to make a list of dividend shares I could buy. I would focus on industries I understood — but I could use this time to expand my knowledge and learn about new industries.
I would keep a clear focus on a company’s likely ability to pay dividends in future, not the past. So I would look for companies with a competitive advantage in industries I felt were likely to be around for years. While I do own some dividend shares in heavily indebted companies, such as British American Tobacco, I would keep an eye on a company’s balance sheet. The more debt a firm has, the less money it may be able to put towards funding dividends when it needs to make interest payments.
I would make a shortlist of companies I felt best met my passive income plan objectives. At the moment, in my own portfolio, I own dividend shares such as M&G, Imperial Brands and Unilever. I chose these shares by following the approach I have just outlined.
Step five: set up a share-dealing account
To buy shares, I would need some sort of share-dealing account or Stocks and Shares ISA. I would shop around to find the one that met my own needs best and set it up.
That way, once I am ready to start buying dividend shares, I could do so without delay.
Step six: start buying a range of dividend shares
Once I had enough money in this account, I could start buying shares from the shortlist I made.
I would try to reduce my risk by diversifying this investment across a variety of companies and industries. That way, if business goes worse than I hope and a company cuts its dividend, the overall impact on my passive income would be lower than if I concentrated my portfolio heavily in one share or sector.
For example, tobacco has high cash-generation potential as an industry. I hold both British American Tobacco and Imperial Brands, which yield 6.2% and 7.6% respectively. But falling demand for cigarettes is a threat to revenues and profits. That could hurt dividends.
In its interim results today, Imperial announced that revenues had fallen 1.3% compared to the same period a year ago and basic earnings per share tumbled 45%. Imperial cut its dividend a couple of years ago and if sales and profits continue to fall, at some point it may be forced to cut it again. Similar risks face British American. But the yields are attractive to me. So I hold both of these tobacco shares, but make sure they form only a limited part of my overall portfolio.
Step seven: watch my passive income plan in action
Once I had taken these steps, hopefully I would start to see my passive income streams increase.
Whether or not I hit £500 in monthly passive income quickly would reflect how I was investing – whether with a lump sum or smaller regular savings. But having identified what I felt were promising dividend shares to buy for my passive income plan, I would then sit back and hopefully let the money start piling up without needing to work for it.