Sitting on a beach while money appears without working for it is many people’s dream. My own passive income ambitions are more modest. But I think a little extra money on a regular basis could come in handy even if I do not expect it to transform my daily life. One way I try to achieve that is by buying dividend shares to set up passive income streams.
Whereas some investments require a lot of money upfront, I like the way that I can begin buying dividend shares even with fairly modest amounts of money. Here is how I would go about it, in five steps.
1. Start saving regularly
If I had enough spare capital, I could start buying shares immediately with the aim of generating £500 in monthly income.
But an alternative option would simply be to decide how much I wanted to save on a regular basis and start doing that. I think being disciplined with myself about putting aside my target amount consistently could help me see the money available to me for investing in dividend shares grow steadily.
To understand how this would help me hit my target, I would need to consider what is known as dividend yield. That is the percentage return I can hope for each year from a share’s dividends based on the price I pay for it.
So, if I invest in shares with an average 5% yield, earning £500 a month in passive income would require an investment of £120,000. If I built up my investment with regular savings, I might take years to reach my £500 monthly income target. But hopefully I would still have some passive income streams while I waited. For example, if I invested £12,000 at average 5% dividend yield, I would hopefully receive monthly dividends of £50.
2. Understand what dividends are — and are not
I said above that I would need to save £120,000 to hit my £500 monthly target if investing in shares with an average yield of 5%.
But I could aim to do it for just £60,000 if I invested in those with an average dividend yield of 10%. Some shares have a yield of 10%+, such as Persimmon, Diversified Energy and Rio Tinto. So, why would I invest in shares yielding 5% when I could invest in 10% yielders instead?
The answer is: risk and reward. In broad terms, the higher a company’s yield the more risk investors may feel it has. Dividends are never guaranteed, and high yields are often a signal that investors expect a dividend cut. For example, if housing demand falls, homebuilder Persimmon may struggle to maintain its profits and dividend. The same could be true for Diversified Energy if energy prices slide, or miner Rio Tinto the next time metal prices fall.
But sometimes, a share with a high yield really does pay out its dividend year after year. Equally, some shares with more modest dividends that have been maintained for decades see a cut. That happened at Shell in 2020, for example. So before even thinking about things like the dividend yields I would need for my passive income streams, I think it would be key for me to learn what dividends are and how companies fund them. Specifically, I would want to learn how to look at a company’s financial reports and make my own judgment about what its future dividends might be.
3. Start choosing dividend shares to buy
Once I understood how dividends worked, I could start making a list of shares to consider buying.
I would stick to businesses I understood or was willing to learn about. That would make it easier for me to assess their future prospects, which can be a difficult thing to do at the best of times. I would also be sure to consider businesses operating in different parts of the economy. Putting too much of my money into similar companies could see my passive income streams shrivel if the businesses did worse than I expected, which is why I would look to diversify.
In identifying the right companies for my own objectives, I would try to find businesses with a competitive advantage that I felt could help them continue to make profits for years to come. I would also search for companies with the capacity to pay out profits as dividends. For example, Aston Martin’s debt pile means that even if it makes strong profits in coming years, I do not expect it to pay dividends. Rolls-Royce has loan terms that mean it cannot pay a dividend this year, no matter how much money it may make. This sort of information is typically contained in a company’s annual report, which is why I think it would be important for me to read them before investing.
Finally I would look at how attractive a dividend was to me financially. Guinness owner Diageo has the sort of attractive business I described above, as far as I am concerned. But its dividend yield is only 2%. As my objective is to set up passive income streams, Diageo might not be among the best shares for me to buy.
4. Make a move
I would set up a share-dealing account or Stocks and Shares ISA.
When I had saved enough money and made a list of dividend shares to buy, I would start purchasing them. I would focus on shares I expected to hold for years, unless something unexpected happened, and be sure to diversify my portfolio from day one.
5. Watch my passive income streams grow
Buying or selling shares usually has a cost, which would eat into my funds. If I bought shares I felt were attractive based on their long-term business prospects and purchase price, hopefully there would not usually be a reason to sell them quickly once I owned them.
So I would sit back and hope to watch my passive income streams grow. If I had not yet hit my monthly £500 passive income target, I would stick to my regular savings schedule and keep buying shares.
Once I did hit my £500 target, what would be my next move? I would set a bigger target for even larger passive income streams in future and start all over again!
