Owning shares that pay dividends is a popular way to build up a second income. It is a passive approach to earning income that allows an investor of limited means like myself to benefit from the business success of proven FTSE 100 companies.
If I had a spare £20k to put in a Stocks and Shares ISA to invest in the current market, here is how I would aim to target a £3,650 annual second income in the years to come. That is equivalent to an extra tenner in my wallet every day.
Choosing the shares
I would be happy to split the money evenly over three shares: British American Tobacco, Legal & General and the City of London Investment Trust.
Why would I choose these shares? I think they each offer the potential for ongoing dividend income. But dividends are never guaranteed. That is why I would diversify across the three shares.
British American has a strong business that benefits from owning well-known brands such as Lucky Strike. But the falling popularity of cigarettes in many markets is a risk to revenues and profits.
Legal & General has a large customer base and strong brand image. But if financial markets wobble and customers start withdrawing more funds, that could hurt profits. The financial services giant cut its dividend during the last financial crisis.
City of London has raised its dividend annually since 1966. The investment trust offers me exposure to a diversified portfolio including dozens of large, well-known businesses. But that also carries a risk that, in a deep recession, its own dividend income would fall. That could lead the trust to reduce its own payout.
Going for gold
The three shares yield 9%, 9.2% and 5.2%, respectively. That would mean my £20,000 ISA could hopefully generate an average yield of 7.8%.
But that adds up to £1,560 per year, a substantial amount, but less than half of my second income target. As a long-term investor, that is where the power of compounding comes in.
By compounding the dividends annually (reinvesting them rather than taking them as cash from my ISA), after 11 years I would hopefully be earning a second income of over £3,650 annually.
Long-term approach
Although I would hopefully earn the income I want buying those three shares and compounding the dividends, it would involve me tying up the £20k in my ISA for slightly over a decade without receiving cash from it during that period.
A second income does not necessarily involve work – but I think it is necessary to be realistic about how to earn money.
By taking a long-term view and following principles of risk management like diversification, I reckon owning this trio of shares could help me hit my second income target. Hopefully I could keep earning thousands of pounds in dividends annually after that, for an investment of £20k today.
