Sometimes you need to spend money to make money. Some people try to earn passive income without spending a farthing, but that often involves a lot of time. For me, that is not really passive. Instead, I put money away on a regular basis and use it to buy shares I think can pay me dividends.
This has several key advantages as I see it. First, it really is passive – I just sit back and hopefully earn dividends. Secondly, such an approach can allow me to benefit from the hard work and success of proven businesses, such as Vodafone or Microsoft. Thirdly, I can save at my own pace, according to my personal financial circumstances. Fourth, I do not need a lump sum upfront to invest, unlike with some passive income ideas.
On top of that, if I buy shares then I am entitled to any dividends they pay for as long as I own them. The unpredicted can always happen, so I mix it up by buying a diversified range of dividend shares. Doing that, if I do not sell the shares, hopefully at least some passive income can keep coming in for decades. In theory, they could turn out to be endless. That said, dividends are never guaranteed.
Making it a habit
If I start with an income target in mind – such as £1,000 per year – then I can work back from there to estimate how much I need to invest to earn it.
Imagine I invest in shares that have an average dividend yield of 5% (in other words, they currently pay out £5 per year in dividends for every £100 invested in them). To earn £1,000 each year, I would need to invest £20,000 in such shares.
I could do that in under eight years by saving £50 a week. If I do not take the money out as income along the way and compound it, I could hit my target faster. Compounding is basically using the income to buy more shares, so that in time my dividends effectively earn dividends themselves.
That could help me hit my target faster, but I may prefer not to compound so that I start receiving at least some income from the first year of my plan onwards.
What shares are good for passive income?
To decide what shares to buy, I would look at the likelihood they would pay large dividends in future.
For a business to do that, it needs to generate a lot of spare cash. So I would look for a company like Unilever or Coca-Cola that had a competitive advantage rivals would find it hard to match. In their case, I think unique brands provide such an advantage.
I would also check a firm’s balance sheet. If it has a lot of debt to pay down, that could mean profits are used for that purpose, not dividends.
Finally, I also consider price. The price I pay for a share impacts the dividend yield I earn — and I want to find bargains.
