We’d all love a second income, right? In fact, that’s the reason many of us invest. It allows us to turn our capital into dividends and can provide us with a financial boost throughout the year.
But how could I go about turning my second income into my only income? Surely it must be possible.
Let’s take a closer look.
How much would I need?
Well, if I have a portfolio of £20,000 and I invested it in high-yielding dividend stocks like Phoenix Group and Aviva, I could expect to average an 8% yield. So my £20k would get me around £1,600 a year in dividends.
Clearly, that’s not enough to live on. It works out at just £130 a month.
So what would I need? Well, in today’s climate, I’d probably want at least £30,000 in dividends a year. And I could earn this without being taxed by investing through my ISA.
But to achieve this I’m going to need something in the realms of £400,000 invested in stocks paying 8% yields.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Getting to £400k
Naturally, building a portfolio worth £400k can sound daunting. And it’s a huge jump to go from just £20,000 to £400,000. There are four key actions required to make it work.
The first is investing over time. It’s not going to happen overnight. We need to appreciate that to build a portfolio worth £400k, we need to invest over a long period of time.
The second action is investing regularly. This allows us to ride out the peaks and troughs of the market. But it’s also important that we keep topping up our portfolio.
Next, I need to invest in dividends stocks. I’m looking for companies with strong but sustainable dividend yields. One way we can assess the health of dividend yield is by looking at the coverage ratio (DCR). Anything above two is healthy. Some stocks will have lower DCRs but healthy cash flows — these stocks are also investment material, in my opinion.
The final action is reinvesting my dividends. Every year I need to take the dividends I earn and pile them back into these high-yielding stocks.
Compounding
Collectively, these actions are the basis of a promising compound returns strategy. This is the practice of reinvesting dividends over time to achieve exponential gains.
For example, if I invested £20,000 in a company with a 8% yield, at the end of the year I could expect to have £21,600, assuming the share price of the stock in question remained constant.
That’s fine, but it’s not groundbreaking. The impressive bit comes when we reinvest that dividend year after year.
Without regular contributions, it would take 38 years to turn £20k into £400k. But if I were to contribute £300 a month, and increased that contribution by 5% annually, I could get there in 21 years.
Naturally, the more I contribute, and the greater my starting figure, the easier it is to get there. And after 21 years, it’s worth highlighting that my portfolio is growing incredibly fast and I may need more than £30,000 a year in two decades’ time.
Of course, there’s no guaranteed way to build a portfolio, and I could always lose money. But if I follow these steps, I stand a good chance of turning my second income into my only income.
