Not all passive income ideas really are passive. That is one reason I like investing in shares.
I can (and indeed have) put some money into shares like British American Tobacco and Dunelm, then sit back and wait for those companies to send me a slice of their profits. Hopefully that will happen on a regular basis.
But as dividends are never guaranteed, I try to improve my income prospects by diversifying my investments across a range of different businesses.
It is possible to try and aim for a certain target using this approach. For example, if I had £20,000 in my Stocks and Shares ISA and wanted to target annual passive income of £1,600 from dividends alone, here is how I would go about it.
Empty shelves
I sometimes imagine my portfolio as a sort of cabinet with lots of shelves. In this case, it could have five to 10 shelves. I would want to split my money evenly across them, meaning I put £2,000-£4,000 into each firm.
That approach helps me diversify, which is an important risk management principle I would use when building passive income streams.
Money plants
Looking at those empty shelves, each one needs something on it.
Some people might be tempted to put what we might call a leaky jar – a pot of money that spilled over quickly. At first that might seem tempting, as it poured out money. But without a way of replacing what it paid, such payouts might not be sustainable. That metaphor explains why I do not invest in shares just because they currently have a high dividend yield. They may be value traps.
Instead, I look for an item closer to a money plant. By that I mean something I could put on an empty shelf that I hope can produce money now and keep on doing so in future. That is how I think of a well-run, profitable business able to support its dividends, thanks to a healthy business performance.
Furnishing the shelves
I would therefore focus my search for passive income streams on finding great companies whose shares I can buy at an attractive price. That may take time, so I would not rush.
Just because my decision process does not start with dividend yield though, that does not mean that I ignore it altogether. I could decide to buy shares in great companies I felt would hopefully help me meet my income target, while passing over other investment opportunities that seem more growth-focussed with lower income prospects.
Alphabet is an example. I think Google’s parent is a great business. But I do not expect it to pay dividends soon, so would not buy it for my ISA if income was my objective.
Building passive income streams
Instead, I would build an income portfolio focused on great companies I also expected could meet my yield target. Generating £1,600 in passive income would require me to generate an average dividend yield of 8%.
Some shares I own currently offer higher yields than that, like M&G and Altria. As the target is an average, I could aim to hit it while still buying some shares with lower yields as long as I generated the right level of dividends overall.
