A second income could come in handy for many people.
But not everyone would want to take a second job to earn it. Fortunately, that is not always necessary. Some people earn a second income through investing in shares and letting major FTSE 100 companies like Shell and Unilever do the hard work on their behalf!
Using such an approach, I think I could aim to turn a lump sum of £40,000 today into a £20,000 annual second income down the line. Here’s how.
The principle of dividends
At the heart of this approach are dividends.
They are basically a way for a company to share its excess cash out among shareholders. Not all companies pay dividends and even those that do can stop at any moment.
So I invest in a diversified range of shares. I focus on finding businesses that I think enjoy a competitive advantage in an area I expect to benefit from long-term customer demand. I also check to see if there is anything that might stop a firm paying a dividend, like a lot of debt on its balance sheet.
Compounding
Still, even if invested in shares that pay large dividends, generating an annual £20,000 from £40,000 seems like a tall order.
That suggests a dividend yield of 50%. But most FTSE 100 companies have yields closer to 3% or 4%. None pays 50% (or anything near it).
That is where the principle of compounding can help me.
It is basically reinvesting the dividends, so that in turn they too earn dividends without me having to put any more money into my investment.
As an example, imagine I own a portfolio of shares with an average yield of 8%. My initial investment is £40,000. By compounding, after 24 years I should be generating over £20,000 of dividends annually.
That does mean that I will need to be patient. If I compound all my dividends until I earn £20,000 annually, I may not be able to draw my second income for decades. But when I do, it could be substantial.
Getting started
Whatever my timeframe, I would get going today.
My first move would be to open a share-dealing account or Stocks and Shares ISA.
Then I would start looking for the sort of shares that meet my objective.
My preference would be for well-established companies with a proven business model and long-term income potential. I would not just focus on dividends. They can always be cut, after all.
I would dig into a company’s accounts and figure out for myself what sort of profits I think it could make in future – and what that might mean for dividends.
