Investing in shares can be one way to set up a second income without having to take on an additional job. In fact, millions of people already own shares and earn dividends from them.
But knowing how much to invest to try and hit a certain target can take some thinking. Here is how I would go about it.
The role of yield
Imagine that I wanted to try and earn a second income of £200 each week from dividends.
Not all shares pay dividends, even if they have in the past. But presuming I put money into shares that did, two things would determine my likely income: the amount I invested and my average dividend yield.
Dividend yield is the annual expected income expressed as a percentage of the purchase price.
For example, at the moment the flagship FTSE 100 index of shares yields 4%. So if I invested £100 in a FTSE 100 tracker, I would hopefully earn around £4 per year in dividends.
Aiming for a target
At that rate, targeting a second income of £200 a week (£10,400 per year) would require me to invest £260,000.
I could lower the amount I invested if I achieved a higher average yield. For example, if the average yield was 8%, the amount I would need to invest would halve, to £130,000.
But simply chasing yield could lead me into what is known as a yield trap.
Sometimes, a high yield indicates the City expects a dividend cut. For example, coming into this year, Direct Line had a double-digit percentage yield. It then cancelled its dividend altogether.
So I always focus first on finding high-quality businesses I think can throw off a lot of excess cash in years to come. Only then do I look at their yield.
Income’s only one part of the equation
I also look at the valuation of a share. Even a good company can be a bad investment if I overpay.
After all, I could earn a decent second income from dividends but lose the same amount (or more) if the value of my holding declines over time before I sell it.
For example, Vodafone yields 10%. But its shares are down 49% in five years.
That said, I am hoping the future will be better for the telecoms company than its recent past and I hold some of its shares in my portfolio.
Building income from zero
I could be wrong of course. Vodafone has a large debt pile, for example. That is why I always aim to diversify my second income streams by buying into a number of different companies.
What if I wanted to aim for a weekly £200 second income but did not have a spare £130,000?
I could start from zero and build up to my target over time.
For example, if I invested £200 a week and compounded my dividends (meaning I used them to buy more shares), then after nine years could have a portfolio earning me dividends of £200 per week on average.
That example presumes constant share prices and dividends, but in reality both could move up or down. But it shows how, even with nothing to start, I could work towards my second income goal in under a decade.
