Building a passive income stream to make money while sleeping is a common financial goal. After all, who doesn’t love the idea of earning a second income. And best of all, when using the power of dividend shares, this idea isn’t as ‘pie in the sky’ as it may seem. In fact, putting aside just £5 a day can be enough to get the ball rolling.
Save regularly, invest occasionally
The concept of owning dividend shares is fairly simple. Mature businesses typically don’t have the ability to generate chunky growth, so some companies choose to pay out the excess cash flow to shareholders instead of being reinvested in the firm. Dividend payouts are typically paid on an annual or quarterly basis. However, be mindful that past dividend yields never guarantee future payouts.
So, by holding these shares in a portfolio, the money can potentially start to grow. And the more shares an investor has, the bigger their slice of the payout will potentially be. Therefore, to some it may seem logical to start buying shares as quickly as possible every day. However, in practice, investors need to consider a few extra factors.
Even if the best dividend stock has been found, investing puts your capital at risk, and owning shares incurs fees when buying and selling. Therefore, simply topping up a position every day with £5 is going to result in a lot of transaction fees eating away at potential returns. Instead, investors should consider letting this money build up in an interest-bearing savings account.
After about a month, that would mean around £150 to invest – a more suitable sum to start with. Plus, if their savings account pays interest on a monthly basis, there could be a little extra capital to work with.
Don’t sit idly
Just because most of the month is spent building up a lump sum of capital doesn’t mean investors can simply sit on their hands. This time should be spent reading and researching which dividend shares are worth buying.
There are plenty of average dividend-paying firms out there. However, owning mediocre businesses isn’t likely to result in much dividend growth. And over the long term, this latter factor is how a passive income stream can become huge.
For example, investors who saw the opportunity that Safestore provided 10 years ago and have held on since are now reaping a dividend yield of over 50% on their original cost basis. In other words, they’re earning a 50% return on investment from dividends alone!
Finding the next Safestore is far easier said than done. However, by analysing both the financial and operational performance of the underlying businesses, investors can better remove duds from consideration.
Managing risk
It’s critical to remember that dividends aren’t guaranteed. They exist as a mechanism to return excess earnings to shareholders. But these payments are entirely at the discretion of management teams, who may decide that capital preservation is more important. And that’s precisely what happened during the 2020 pandemic.
As such, a lucrative dividend stock today might be a disaster tomorrow. Analysing a firm’s cash flow generation can help mitigate such risks. But all it takes is one unforeseen external factor to cause disruption. Therefore, investors should also strive to diversify their portfolios.
By owning a collection of dividend-paying companies, the impact of one failing can be minimised.
