Income stocks are a terrific way to earn some extra cash on the side. By building a diverse portfolio of dividend-paying enterprises, a steady flow of revenue can make its way into my bank account or provide the funds to reinvest and grow this income stream over time.
What’s more, it doesn’t actually take that much capital to get the ball rolling. Even with just £50 a week, it’s possible to establish a £2,663 passive income within a decade. Here’s how.
The power of reinvesting dividends
Investing £50 a week is the equivalent of £2,600 a year. And in the grand scheme of things, that isn’t exactly a lot of money. But by reinvesting any dividends received, it’s possible to introduce some extra compounding into this equation. And that can end up changing things quite drastically. Let me demonstrate.
Looking at the FTSE 100, UK shares have traditionally offered around 4% annualised returns through capital gains and another 4% via dividend yield. Thanks to the recent stock market correction, investors can be a bit more selective to push the yield closer to 6% without taking on too much extra risk.
So how much would my portfolio be worth with and without dividend reinvestment over the next 10 years at these rates?
| Years | No Dividend Reinvestment | With Dividend Reinvestment |
| 1 | £2,648.20 | £2,722.54 |
| 2 | £5,404.30 | £5,730.17 |
| 3 | £8,272.68 | £9,052.74 |
| 4 | £11,257.93 | £12,723.23 |
| 5 | £14,364.80 | £16,778.06 |
| 6 | £17,598.25 | £21,257.48 |
| 7 | £20,963.43 | £26,205.96 |
| 8 | £24,465.72 | £31,672.62 |
| 9 | £28,110.70 | £37,711.70 |
| 10 | £31,904.17 | £44,383.15 |
Looking at the table, reinvesting the 6% yield received from income stocks resulted in a £12,482 difference. In terms of passive income, it’s the difference between earning £2,663 per year and £1,914 – a 39.1% increase!
Nothing is risk-free
The idea of generating meaningful passive income without having to lift a finger is undoubtedly exciting. Sadly, dividends aren’t always the most reliable source of income.
Dividend payouts serve as a mechanism for businesses to return excess earnings back to the owners (the shareholders). But suppose an enterprise stops generating this extra income? Or perhaps discovers an internal project that serves as a better use of capital? In that case, dividends may end up getting cut or even outright suspended.
In the wake of the global pandemic, even FTSE 100 companies hit pause on shareholder dividends to ensure they had sufficient liquidity to keep the lights on while everyone was stuck in lockdown. And while another pandemic may seem unlikely, that’s not the only threat companies have to face on a daily basis.
This is where diversification enters the picture. By owning a wide range of income stocks operating in different industries and geographies, the risk of disruption is far more likely to be isolated to a small part of an overall portfolio.
In other words, if one source of dividends gets cut off, investors will continue to earn income from other companies that remain unaffected.
