One way to earn passive income is owning shares that pay dividends. Doing that, I can benefit from the proven businesses and ongoing efforts of companies like Vodafone and Legal & General.
I do not need to do any work, but if they pay dividends I can share in the firms’ cash distribution.
Many UK share prices right now mean that their dividend yields are high. Vodafone and Legal & General, for example, yield 10.9% and 9.2% respectively.
If I had a spare £10,000 to invest at the moment, I would take advantage of this market environment to try and build an annual passive income stream of £1,000.
Balancing risks and rewards
Putting £10,000 into the 10.9%-yielding Vodafone could potentially help me do that in one fell swoop. But that would mean concentrating all my risk in one share.
What if the company cuts its dividend due to the cost of servicing its heavy debt load? Dividends are never guaranteed and Vodafone has form in reducing its payout.
On top of that, if I put all my £10,000 into one share and its price falls, I could lose money if I sold my holding. The Vodafone share price has more than halved in five years.
That sort of risk helps explain why I focus on risk not just potential reward when hunting for shares to buy. With £10,000 I could diversify across a handful of different companies.
Quality first
Instead of looking at yield alone, I would start my search by identifying what I think are great businesses with substantial long-term income generation potential.
After all, my passive income plans depend on the businesses throwing off excess cash and then distributing it in the form of dividends.
Yield target
Following that, if such shares were attractively valued, I would consider their prospective dividend yield.
With multiple FTSE 100 shares already yielding close to 10%, I might me able to hit that yield target and earn £1,000 in annual passive income from the off. But if not, I still think the target is realistic. I just need to be patient.
For example, if I spend £10,000 on shares with an average dividend yield of 8% and reinvest the dividends at first (known as compounding) then after four years, I would be earning over £1,000 in dividends annually.
At that point, I could choose to stop compounding and use the dividends as a passive income stream.
Compounding has been a powerful investing tool for centuries and will remain so. The high yields currently offered by some UK shares mean I see now as a particularly attractive time to buy them for my portfolio.
Doing that could set me on the path to earning a four-figure passive income in coming years.
