Trying to set up passive income streams that really do not involve work can be a challenge. One approach is to invest in shares. But while that may not require much (if any) work as such, it does take money.
With a long-term approach to investing though, I think it is possible to try and set up sizeable passive income streams even with a constrained budget. If I had a spare £10,000 in savings, for example, and wanted to target annual dividend income of £5,000 down the line, here is how I would go about it.
Get the ball rolling
First I would set up a share-dealing account, or Stocks and Shares ISA to house the money. That way, when I was ready to buy shares, I would be able to do so without delay.
Then I would start researching what sort of shares might help me reach my passive income goal. It could be tempting to do this simply by looking at dividend yield. Diversified Energy, for example, has a yield of over 18%. That certainly sounds juicy to me!
But the issue with focusing on yield is that it is a backwards-looking approach in that the dividend is what has been paid before. Dividends can be cut or cancelled at any time.
So instead, I would try to find companies I thought could throw off substantial free cash flow in future and are trading at an attractive valuation.
An example from my portfolio is British American Tobacco. Cigarettes are cheap to produce but can be sold at a high price. That helps the company pay big dividends. Currently, the Pall Mall owner had a 9% yield.
Building a portfolio
But the world is changing and cigarette consumption is falling in many markets. Although British American is building its non-cigarette business, could a future fall in free cash flow lead to a dividend cut?
It is possible, which I why I never put all my passive income eggs in one basket. With a spare £10,000 I could split the money evenly across five to 10 different shares.
Earning dividends from income shares
Although the current yield would not be my starting point when assessing potential purchases for my portfolio, I would still consider it at some point. The yield helps me understand how much passive income I might earn each year.
For example, if I managed to achieve an average dividend yield of 8% annually, my £10,000 could earn me £800 each year.
Building income thanks to compounding dividends
Still, although £800 in annual passive income would be welcome, it is a far cry from my yearly target of £5,000.
I said above that I would take a long-term approach. Specifically, rather than taking the dividends as cash to start, I would reinvest them in more shares. This is known as compounding.
Doing that, presuming flat share prices and dividends, I would be earning over £5,000 in passive income annually after 24 years.
In reality, dividends and share prices can move up or down. But the point is clear, without putting in another penny, compounding could help me try and increase my passive income streams over time.
