With interest rates moving up, it is now possible for some savers to earn a decent return on money in a savings account. Still, if I had a lump sum and wanted to use it to generate extra income, I would rather put it into shares given some of the bargains available in today’s market.
Buying shares carries risks that putting money into a bank account typically does not. But I think I could earn more income putting money into the stock market than a savings account, even allowing for such risks.
If I had a spare £20,000 of money today I wanted to put to work, here is how I would target annual extra income of £1,600.
Setting some ground rules
Although I am willing to tolerate some risk, that does not mean I want to act rashly. Quite the reverse, in fact.
So my first move would be setting some rules for myself about how to invest when trying to earn extra income. Every investor is different, as each has their own circumstances.
For me, I would stick to well-known companies from the FTSE 100 and FTSE 250 indices.
I would limit my search to companies with a track record proving they have had a profitable business model that funded high dividends. That is not necessarily an indicator of what may happen in future. But making profits can be harder than it looks, so I would prefer to invest in firms that have already demonstrated they can do it.
To reduce my risk, I would diversify across different companies and sectors. £20,000 is enough to let me spread the money evenly over five to 10 companies. My focus would be squarely on businesses I understood.
Another consideration would be how much spare cash I expected a firm to throw off even after paying for things like capital expenditure and debt repayment.
A company like 10.5%-yielding Vodafone can generate a lot of free cash flow – but its capex needs and groaning balance sheet could yet pose a risk to the dividend.
Building the portfolio
So, what sorts of shares might I buy?
My target of £1,600 in annual extra income implies an average dividend yield of 8% on my £20,000.
That is only an average, though. So if I buy some shares yielding 8% or above, I could also purchase some with a lower yield.
Right now, a number of FTSE 100 shares I own yield more than 8%. Examples include British American Tobacco, Legal & General and M&G.
Others I would consider adding to my portfolio if I had a spare £20,000 include Phoenix and Aviva. Of those, only Aviva yields less than 8% — and it is still on an impressive 7.8%.
Looking at that list though, financial services dominates. In building a portfolio I would want to stick to my diversification principle. High yields in financial services could signal a risk that a weakening economy leads to falling customer demand and lower profits.
With careful research and investing, I think my £1,600 annual target could be achievable.
