The prospect of generating a meaningful second income without needing to take on an additional job is appealing. I aim to do that by building a portfolio of dividend shares.
One thing I like about this approach is that it does not require a big sum of money upfront. I could put aside some cash each month and build my income over time.
Here is an example of how I could use £280 each month to target a long-term second income goal of £20,000 per year.
The power of regular saving
I have chosen £280 as an example. Everyone’s financial circumstances are different. I think it helps to set a challenging but realistic target, based on circumstances.
That would add up to £3,360 per year. I would put the money into a share-dealing account, or Stocks and Shares ISA, so I would be able to invest it immediately if I found shares I liked.
Understanding dividends
At the heart of my plan is buying shares I hope will pay me dividends. A dividend is a bit like being paid a cut of a company’s profits. Not all firms pay them, even when they make money. For example, Google parent Alphabet is hugely profitable but pays no dividends.
Finding shares to buy
So what sort of companies do pay dividends – and look likely to keep doing so in future?
I hunt for businesses that operate in a market I expect to keep having high customer demand. A supermarket like Tesco or consumer goods maker such as Unilever would fit the bill. I then look for some competitive advantage that might allow a firm to make large profits over the long term. For example, Unilever’s range of unique brands gives it pricing power.
Another thing to consider is a company’s balance sheet. Does it have debt that could lead to a dividend cut? That is a risk I see in my current holding Vodafone.
Price matters
I then look at the dividend yield. That is a company’s annual dividend as a percentage of the share price. In other words, I can get a higher yield by buying a share when its price is low, instead of when it is high.
Price matters in other ways too. Although my focus is dividends, if I overpay for shares, I may see the value of my holding decline. Sometimes a company cuts its dividend, like Direct Line did last month. Such a move can lead to the share price falling.
Imagine I had bought Direct Line last year in anticipation of a high yield. I would now be looking at zero dividend income for the foreseeable future – and my holding would be worth 40% less than I paid for it.
Such risks also explain why I diversify my portfolio across different companies.
Building a second income
Imagine I manage to earn an average annual yield of 5%. If I reinvest the dividends as I go (known as compounding) I could hit my £20,000 a year second income target in 40 years.
Clearly this is a long-term approach. I could also speed things up if I invested more each month, or achieved a higher average yield. At an 8% average annual yield, for example, I could reach my goal after 25 years.
