7 steps to earn a £20,000 second income

Want to earn a £20k second income by investing in dividend stocks? Charlie Carman explains how to approach this goal using seven simple steps.

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There are many ways to earn a second income, from affiliate marketing to buy-to-let properties. Each has merits and disadvantages. Regarding my own finances, I choose to buy dividend shares in pursuit of this aim.

If I were to start investing in stocks from scratch today, here’s how I’d target £20k in annual dividend payouts.

1. Save regularly

The maxim “it takes money to make money” rings true when it comes to dividend investing. To generate a second income I’ll need spare cash to invest.

There’s no right amount to save, but getting into good habits is crucial. Of course, the more I’m able to invest, the faster my journey to a £20k dividend haul will be.

2. Open an ISA

Once I’ve started accumulating money, I need to choose an investment account. With no taxes on capital gains or dividends from equities held in a Stocks and Shares ISA, this could be an attractive option.

Selecting the right ISA depends on each individual’s investment goals, the range of stocks offered, and fee structures.

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.

3. Research

Conducting careful research on dividend shares before investing is critical. To paraphrase the legendary billionaire Warren Buffett: “Never invest in a business you can’t understand“.

Considering Buffett’s unparalleled success in the stock market, this advice is worth heeding.

4. Buy dividend stocks

After compiling a well-researched watchlist, it’s time to buy dividend shares. Many FTSE 100 stocks offer juicy yields, so the UK’s flagship index could be a good place to start.

It’s important to look beyond the headline yield figure. Dividend cover and a reliable history of delivering passive income are crucial factors too.

For instance, some FTSE 100 shares with robust coverage ratios and impressive track records of payouts spanning decades include:

StockDividend YieldDividend Cover
British American Tobacco9.1%1.7x
London Stock Exchange Group1.3%3.0x

5. Diversify

It’s important not to be overly exposed to any individual company. Diversification can reduce volatility in an investor’s portfolio.

Diversification takes many forms, depending on an individual’s risk tolerance. Some prefer to own as few as a dozen shares, others invest in index funds or alternative asset classes, such as bonds, to complement their hand-picked stocks.

6. Compound returns

So, how long will it take to turn my portfolio into a £20k second income generator?

There are many variables, but let’s imagine I invested £300 a month and my portfolio grew at an 8% compound annual rate. If I secured a 4% yield across my stocks, I’d reach my goal in under 32 years.

For those who can afford it, doubling contributions to £600 a month would cut the time frame to less than 24 years.

7. Risk management

Although dividend investing is a tried-and-tested strategy, it’s vital to remember that distributions aren’t guaranteed and share prices can fall.

Careful research, diversification, and adopting a long-term investing mindset are good ways of mitigating these risks. Additionally, emotional preparation for gut-wrenching falls in my portfolio’s value is equally important so I don’t sell in a panic when the going gets tough.

It won’t always be a smooth ride, but targeting a £20k second income from dividend stocks is a realistic target for a disciplined investor.

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.

Charlie Carman has positions in British American Tobacco P.l.c and Diageo Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Diageo 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.

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