I’d invest £500 a month to target a £45,000 second income from dividend shares

Regularly investing money in the stock market can build a substantial portfolio capable of generating passive income through dividend shares.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Diverse group of friends cheering sport at bar together

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Even though the recent stock market rally has pumped up the valuations of leading dividend shares, there are still plenty of UK income stocks trading at good prices. Building a diversified portfolio of high-quality businesses today could lead to a surprisingly large nest egg for a more comfortable retirement.

In fact, drip-feeding just £500 a month into the stock market could produce a seven-figure portfolio generating £45,000 in annual passive income. Here’s how.

Finding high-quality dividend shares

As previously mentioned, not every dividend-paying stock has recovered from the 2022 correction. And for investors brave enough to buy these discounted shares even with all the economic uncertainty, greater wealth can potentially be unlocked in the long run.

However, it’s essential to avoid falling into classic income traps. While the adverse macroeconomic environment is already improving, its short-term effects might have permanently damaged certain businesses. Even the firms whose operational cash flows have already recovered may be in trouble if their balance sheets are riddled with debt.

After all, rising interest rates make servicing loan obligations more expensive, with fewer financial resources left over to fund payouts from dividend shares. But for the companies still in robust shape, these short-term disruptions may soon be over, paving the way for prosperity as overleveraged rival firms struggle to get back on their feet.

Turning £500 into £45,000

Looking at the FTSE 100, the average dividend yield among the largest listed enterprises in the UK currently stands at roughly 3.5%. Therefore, to generate £45,000 from 3.5%, an investor will need a portfolio worth just over £1.28m.

Needless to say, that’s not exactly loose change. But as crazy as it may seem, consistently investing £500 each month can establish a nest egg of this size in the long run. To accelerate the process, investors can turn to a more growth-focused index such as the FTSE 250.

Historically it has produced average annualised returns of 10.6%. And investing £500 a month at this rate would theoretically result in a portfolio worth £1.29m in just under 30 years. This could potentially unlock an earlier retirement for individuals in the early years of their careers.

When the threshold is hit, investors can reallocate their capital to the FTSE 100 index and reap an annual 3.5% yield. Alternatively, they could choose to pick individual dividend shares to increase their passive income stream. Even if the portfolio yield grows to just 4%, that’s an extra £6,200 a year.

Nothing is risk-free

As exciting as the prospect of earning nearly double the average UK salary in passive income is, it’s important to remember that the stock market can be volatile.

There’s no guarantee that indexes’ past performance or dividend yields will continue for the next three decades. Moreover, crashes and corrections occasionally rear their ugly heads, disrupting the wealth-building process. And depending on the timing of these events, an investor may end up with considerably less than expected.

Nevertheless, the potential rewards of dividend shares make these risks worth taking, in my opinion.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Black woman using loudspeaker to be heard
Investing Articles

I was right about the Barclays share price! Here’s what I think happens next

Jon Smith explains why he still feels the Barclays share price is undervalued and flags up why updates on its…

Read more »

Investing Articles

Where I’d start investing £8,000 in April 2024

Writer Ben McPoland highlights two areas of the stock market that he would target if he were to start investing…

Read more »

View of Tower Bridge in Autumn
Investing Articles

Ahead of the ISA deadline, here are 3 FTSE 100 stocks I’d consider

Jon Smith notes down some FTSE 100 stocks in sectors ranging from property to retail that he thinks could offer…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

Why I think Rolls-Royce shares will pay a dividend in 2024

Stephen Wright thinks Rolls-Royce shares are about to pay a dividend again. But he isn’t convinced this is something investors…

Read more »

Investing Articles

1 of the best UK shares to consider buying in April

Higher gold prices and a falling share price have put this FTSE 250 stock on Stephen Wright's list of UK…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

The market is wrong about this FTSE 250 stock. I’m buying it in April

Stephen Wright thinks investors should look past a 49% decline in earnings per share and consider investing in a FTSE…

Read more »

Black father and two young daughters dancing at home
Investing Articles

1 FTSE 250 stock I own, and 1 I’d love to buy

Our writer explains why she’s eyeing up this FTSE 250 growth phenomenon, and may buy more shares in this property…

Read more »

View of Tower Bridge in Autumn
Investing Articles

The FTSE 100 is closing in on 8,000 points! Here’s what I’m buying before it’s too late!

As the FTSE 100 keeps gaining momentum, this Fool is on the lookout for bargains. Here's one stock he'd willingly…

Read more »