Passive income is arguably the greatest form of financial freedom. Receiving regular cash payouts from dividends not only allows investors to enjoy a comfortable retirement, but it also means they can avoid the headache of deciding which stocks to sell to fund their desired lifestyle.
However, living purely off dividend income does demand a sizeable portfolio. That might be easy for high earners to achieve, but not everyone has bags of spare cash to lock away in the stock market for years.
So, here’s how I’d aim for £1,500 a month in passive income by investing the relatively modest sum of £5 a day.
Buying dividend stocks
When searching for dividend shares to buy, it’s important to look at different metrics. A good place to start is the dividend yield.
For example, let’s focus on three popular FTSE 100 stocks that feature in my portfolio. Diageo currently offers a 2.8% yield. Tesco sports a higher 3.9% yield. Yet both are dwarfed by British American Tobacco‘s mammoth 10% yield.
But, investors should also consider a company’s distribution history. This is a critical measure of dividend reliability.
To illustrate this, British American Tobacco (known as BAT) and Diageo both claim coveted Dividend Aristocrat status, but Tesco’s track record is more chequered. The supermarket suspended dividends for three years due to an accounting scandal in 2014.
Moreover, dividend cover is another useful indicator to bear in mind. This can provide insight into how sustainable a stock’s passive income payouts are. Typically, cover of two times earnings indicates a good margin of safety.
Tesco and Diageo both meet this threshold, but BAT’s dividends are only covered by 1.7 times earnings. Accordingly, it’s fair to say every dividend stock has its merits and downside risks, as my examples demonstrate.
Reinvesting passive income
Across my portfolio, I’d set myself an ambitious but realistic goal regarding the average dividend yield. As a benchmark, the FTSE 100 index currently yields 3.8%. However, since I’m investing exclusively in dividend shares, I’d aim for a higher yield of 5%.
To earn £1,500 in monthly passive income I’d need a portfolio worth £360,000. An excellent way to accelerate my journey to that total might be to follow a dividend reinvestment strategy.
This would allow me to benefit from higher compound returns until the time comes when I need the passive income to fund my spending commitments.
If I secured a 10% compound annual growth rate across my portfolio from a combination of dividend reinvestments and share price growth, I’d reach my target in a little over 31 years. Not too shabby from investing just a fiver a day over my working lifetime!
Managing risks
I’m a big believer in the advantages of dividend investing, but it’s not a risk-free endeavour. Companies can cut or suspend their distributions at any time. In addition, stocks are notoriously volatile assets and capital growth isn’t guaranteed.
Nonetheless, I can mitigate these risks to some extent by diversifying my portfolio across different equities in different sectors, as well as keeping a solid emergency fund in cash before investing a single penny.
Provided all goes to plan, I stand a good chance of turning my passive income dreams into reality for as little as £5 a day!
