Dividend shares have often been a popular destination for income-seeking investors. However, thanks to all the ongoing stock market volatility this year, many now offer impressive capital gains returns as well.
After all, with stocks being sold off on investor fears, plenty of top-tier businesses are now trading at a discount. And that includes the companies that aren’t affected by the macroeconomic factors plaguing the markets.
For investors diligent enough to spot the firms caught in the crossfire, the probability of outperforming the stock market in the long run increases drastically. In fact, today’s investment decisions could eventually yield an annual income of £40,000 with only a modest sum of capital.
Unlocking passive income with dividend shares
Looking at the FTSE 100, the British stock market offers an average dividend yield of around 4%. So, for investors with £1m in the bank, building a £40,000 annual income stream should be a piece of cake. Sadly, not everyone has the privilege of a seven-figure bank account.
Fortunately, there are multiple ways for investors, even those starting from scratch, to get to this impressive financial position.
I could start saving as much as possible, invest in real estate, or buy bonds. While there’s nothing particularly wrong with these approaches, today’s low-interest rate environment, even after the recent hikes, doesn’t offer particularly impressive returns. Or at least not when compared to dividend shares.
One of the easiest ways to tap into this income stream is arguably buying a FTSE 100 tracker fund. The index has historically yielded an annualised return of around 8% after reinvesting dividends. So if I were to allocate £500 each month from my salary at this rate of return, my portfolio would hit £1m within 34 years.
Alternatively, I can take a riskier approach of buying shares individually. By targeting specific high-quality companies, I can potentially hit a higher average return. Even if I can only muster a 10% average, that’s still enough to chop off five years from the waiting time to reach millionaire territory and my £40,000 passive income.
Managing expectations and risks
While the waiting time is far from ideal, the prospect of generating £40,000 each year without having to lift a finger is undoubtedly exciting. But it’s worth remembering nothing is guaranteed.
The previous calculation made the fundamental assumption that the FTSE 100 will continue delivering an 8% annualised return moving forward. But past performance is not a good indicator of future results. And it’s entirely possible that the rate of return could be lower, drastically increasing the waiting time.
Having said that, the low entry price available today, thanks to the ongoing stock market correction, does present a rare opportunity. Throughout every other economic wobble in history, buying strong dividend shares while they’re cheap has unlocked market-beating returns in the long run.
So while investing in stock is never risk-free, it’s still a risk worth taking, in my opinion.
