Some extra money could come in very handy. That is why many people try to generate a second income. One way to do that is buying shares.
Here is how I would use that approach if I wanted to target an extra £1,000 a month in passive income.
Buying shares for extra income
First let me explain what I see as the attractions of buying shares to generate a second income.
Large FTSE 100 companies like Shell and HSBC have well-established businesses that are often massively profitable. As they are listed on the stock exchange, I can buy shares in them. That gives me a tiny stake in a firm. One of the benefits that goes along with that is the prospect of receiving dividends.
Dividends are how a company divvies up its profits out with shareholders. But there is no obligation to do so. Even some highly profitable firms, such as Google parent Alphabet, do not pay a dividend.
So if my objective is to build a second income, I need to choose carefully when buying shares for my portfolio.
Dividend shares to buy
Some investors look at a company’s track record when making such choices. But as dividends are never guaranteed, just knowing that a company made handsome payouts in the past is no assurance that it will do so again.
Instead, I focus on whether I think a business will consistently be able to generate spare profits in future. For example, does it have a large market of potential customers? Is there something about its business such as a brand, piece of technology, or a distribution network than can set it apart from competitors? Is the company’s balance sheet healthy enough that profits can be used to fund dividends?
This is an art not a science, as even the best-run company can sometimes come a cropper. An unexpected turn of events, perhaps outside its control, can change a firm’s outlook in short order. So I make sure to keep my portfolio of dividend shares diversified across a range of companies.
Income streams
How much would I need to invest to earn an average monthly second income of £1,000?
The answer depends on the average dividend yield of the shares I buy. Yield is my expected annual dividend income expressed as a percentage of what I pay for the shares.
If I achieve an average yield of 5%, for example, I would need to invest £240,000 to hit my target. But I could build up to that over time, putting a few hundred pounds aside each month and hopefully watching my second income increase.
I could also hit my target investing less, if I achieve a higher average yield. For example, at an 8% yield, I could hit my target by investing £150,000.
But while I own some high-yield shares in my portfolio, I never buy one just because of its yield. My focus is always on finding attractively-priced strong businesses I think can generate substantial profits for the long term.
