How I’d invest £20k in dividend shares to earn a second income

Our writer explores a three-step process he’d use to find and invest in the best dividend shares to produce a regular and reliable income stream.

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.

Storytelling image of a multiethnic senior couple in love - Elderly married couple dating outdoors, love emotions and feelings

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.

Dividend shares can be an excellent way to earn passive income. Many listed companies pay a portion of their profits to shareholders in the form of dividends.

But not all companies do so. Some firms reinvest profits to grow the business. To earn regular income though, I’d focus on dividend-paying shares.

Many of these can be found in the FTSE 100. That’s because this large-cap index holds many mature and established companies. These tend to be more focused on providing stable and consistent dividends rather than aiming to multiply the size of their business.

Finding stocks to buy

To find the best dividend shares, I’d use a 3-step process:

First, I’d look for a high dividend yield. The average for the FTSE 100 is currently around 3.5%. That doesn’t sound compelling right now though. So investors may want to aim higher. That said, bear in mind that a double-digit yield might not be sustainable either. So where is the sweet spot? I’d look for a range of 5% to 8%.

Next, I’d find companies that have a history of paying reliable and consistent dividends. Many of the best dividend shares have been paying consecutive payments for decades. These sound far more reliable than ones that have just started.

Finally, I’d assess the company’s financial health. As dividends are typically paid from earnings, a healthy outlook for sales and profits is most welcome. Earnings should be large enough to comfortably cover dividend payments.

Spreading out my £20,000

Once I have a shortlist of shares, I can decide how to turn £20,000 into a second income stream.

I wouldn’t invest it all in just one or two shares. Instead, I’d diversify my portfolio across several stocks and different industries. This will help spread the risk and avoid putting all my eggs in one basket. That way, if one of my stocks underperforms, it shouldn’t impact my overall portfolio by as much.

Bear in mind that much can happen with companies over time. I’d need to monitor them to ensure they continue to meet my criteria. And if they don’t perform, then I’d consider swapping them for some dividend shares that do.

Which shares?

Some Footsie companies that currently meet my criteria include Phoenix Group, Legal & General, British American Tobacco, Rio Tinto and Sainsbury’s.

All five of these dividend shares operate in distinctly different industries. They don’t cover all of the sectors, but I’d say they are sufficiently diversified.

On average, this group offers a 6.7% yield and over 22 years of consecutive dividend history. With an average dividend cover of 1.6, I’m comfortable they all have sufficient earnings to cover payments.

If I had £20,000 to invest in an income portfolio right now, I’d buy all five shares and split my funds equally between them.

As a result, I’d expect to earn at least £1,340 in dividends a year. In addition, companies sometimes distribute special dividends. These are extra payments from excess cash flow. But as these are ad-hoc, I’d treat them as a bonus.

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.

Harshil Patel has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. and J Sainsbury Plc. 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

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

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

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

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

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »