Passive income is as simple an idea as it sounds: earning money without working for it. But while the idea may be simple, the reality can be more complicated. A lot of people put time into plans that seem anything but passive to me.
By contrast, my approach of earning dividend income by investing in shares involves very little time commitment on my part. Here is a description of how I could use such a plan to target a weekly passive income of £100.
Buying dividend shares
Not all shares pay dividends, even if they have done so in the past. So when building a portfolio with the objective of passive income, I focus on the long-term cash generation potential I think a business has.
For example, does it have some unique advantage in a field likely to experience ongoing high customer demand? Could that be turned into profits that can fund dividends, or might they need to be used for other purposes, such as paying down debt?
An example of a share I own for its passive income potential is financial services company Legal & General. I expect demand for financial services to remain high in the long term. With a large customer base and strong brand, I think Legal & General has a competitive advantage within that field.
At the moment, its dividend yield is 9%. That means that for every £100 I invest in Legal & General shares today, I will hopefully earn £9 in dividends annually.
Risk management
I say ‘hopefully’ because dividends are never guaranteed. So although I happily own shares in Legal & General, they form only one small part of a portfolio diversified across a range of companies and industries.
Aiming for a target
Still, although dividends are not guaranteed, I use the average prospective yield of my portfolio to predict my passive income.
If I wanted to target £100 a week (£5,200 annually) then, if I earn an average yield of 5%, I would need to invest £104,000 to hit my target. If I managed an average yield of 8%, by contrast I could hopefully hit my target by investing £65,000.
But I would not invest on the basis of yield alone. Instead, I always look at what I think are a company’s long-term financial prospects and its valuation. Only then do I consider the yield.
Step by step
But many people do not have a spare £65,000 or more sitting around. Even starting with nothing, I could still work towards my passive income objectives. I would start by setting up regular payments suitable for my own financial circumstances into a share-dealing account, or Stocks and Shares ISA.
After that, I would use the money to buy more shares over time and build up my portfolio. Although doing that could take me years to reach my £100 weekly passive income target, I would hopefully earn dividends along the way.
