Owning dividend shares can be a lucrative source of passive income. Simply by investing in a few well-known companies that divvy up some of their profits among shareholders, I can hopefully earn money regularly without having to work for it.
If I had a spare £10,000 to invest right now, here is how I would use it to target annual income of £700. Over the years, hopefully, that sum could increase if dividends grew.
Start with the end in sight
If I want to earn £700 in annual dividend income from a £10,000 portfolio, I will need to achieve an average dividend yield of 7%.
I do not start investing by looking at yield. Instead, I look for great businesses selling at attractive prices. If I can find such firms though, I would then look at their dividend yield.
Building a portfolio
Right now, there are a few companies I think match my investment criteria that could help me achieve that average yield. From the FTSE 100, for example, I might choose British American Tobacco, M&G and Legal & General.
Note that I am thinking here in terms of a range of shares, not just concentrating my money in what I see as the single best investment idea. That is because I think diversification is a critical risk management tool for investors. £10,000 is ample to diversify. I could split it evenly across five different shares, for example.
Avoiding yield traps
But sometimes, high-yielding shares can make me nervous as an investor. The yield might be a red flag that investors expect the dividend to be cut, for example.
M&G currently yields 10%. That seems unusually high to me compared to most shares on the London Stock Exchange. The company’s policy is to try and maintain or raise its annual dividend. M&G raised its interim dividend this year. It has also bought back £500m of its own shares this year. That means that, with fewer shares in circulation, it could pay a higher dividend per share than before, without needing to spend more money.
Still, is the 10% sustainable? After all, dividends are never guaranteed. So I look at how robust a business is, what competitive advantages it enjoys and what its free cash flows look like. Ultimately though, I can still make mistakes – or circumstances can change. That is why I keep my portfolio of dividend shares diversified.
Letting dividend shares do the work
Once I have invested the £10,000, what should I do?
I am a long-term investor, not a trader. So I would simply sit back, put my feet up and, hopefully, let the dividends roll in. If the companies do well and grow their payouts, in time I may earn even more than my target £700 in passive income each year.
I would keep an eye on the shares from time to time, paying attention to anything that I felt changed the investment case for them. But rather than jumping in and out of the markets frequently, I would adopt a genuinely passive approach while the dividends started to pile up.
