Income shares hopefully do exactly what they say on the tin: generate income. Simply by buying and holding them, I could potentially reap dividends.
That is never guaranteed, as even companies that have paid dividends before can choose to stop doing so.
But by building a carefully chosen, diversified portfolio of income shares, I reckon I ought to be able to aim for substantial passive income streams.
If I had a spare £9,300 and wanted to do that with the goal of earning £500 each month on average in dividends, here is how I would go about it.
Understanding dividend yields
The amount of dividends I might earn depends on how much I invest and the dividend yield. Yield is essentially the dividends I expect to earn each year expressed as a percentage of the price I pay for the shares.
£500 each month adds up to £6,000 in a year. That is equivalent to an annual dividend yield on £9,300 of 65%.
No FTSE 100 share (and very few income shares anywhere) offers a yield anything like that. Vodafone (LSE: VOD) is among the highest paying FTSE 100 shares — and its yield is 11.5%.
Focusing on quality and value
I own Vodafone shares in my portfolio. But that does not mean I earn a yield of 11.5%. Partly that is because Vodafone is only one of the income shares I own. Diversification is a simple but important risk management tool for an investor.
My yield on Vodafone is lower than if I had bought it today, because the share price was higher than it is now when I added the telecoms giant to my portfolio.
Why has the price been falling despite a high yield? I think that reflects concerns some investors have about the risks for Vodafone. From a large debt burden to the risk that selling businesses leads to lower revenues and profits, there are various grounds for concern that the dividend could fall.
Still, I like the company’s strong brand, large customer base and leading position in multiple markets. Whether my optimism is well-founded or not, one thing shines through. Buying a share purely because it has a high yield is not investment so much as speculation.
When deciding whether to add income shares to my portfolio, I always consider their business prospects and valuation above all else.
Aiming for £500 in monthly passive income
Imagine, then, that I can build a diversified portfolio of shares earning me an average yield of 7%. That is higher than the FTSE 100 average but I think is possible while keeping a clear focus on quality and valuation.
Earning 7% of £9,300 each year in dividends is nothing like my target of £500 a month.
But imagine I reinvest the dividends such that my portfolio value compounds at 7% annually. Then after 34 years I ought to be earning over £500 every month on average in dividends from my income shares.
That sounds like a big wait. But I think using a long-term approach to investing could work to my advantage. Doing that, I could realistically try to set up sizeable passive income streams with under £10,000 to spare.
