A second income’s a great way to safeguard against life’s unexpected problems. Should it be a sudden medical emergency, an untimely redundancy, or just that winter coat you’ve always wanted.
As quoted by legendary investor Warren Buffett: “Never depend on a single income, make an investment to create a second source.”
Easier said than done though. Working a second job or starting an online business is time consuming. Not everybody has the luxury of that free time.
There is however, a way to build a second income by investing in the stock market. Companies that pay dividends are a particular favourite of income investors. They reward their shareholders with regular payments calculated as a percentage of the amount invested. This is called the ‘yield’.
Investing a lump sum into a portfolio of dividend-paying shares is one way to earn some extra income. But, of course, it comes with risk. Dividends can be cut or reduced and share prices can fall.
As always in life, there’s no such thing as easy money. But this risk can be minimised by carefully evaluating and selecting the right shares.
Which stocks to pick?
For sufficient returns, the stock should have a yield above 5%. Yields drop as prices rise, so a good dividend payer should increase dividends in line with growth to maintain consistency.
As such, a good dividend payer should have a long track record of increasing payments. The occasional reduction due to economic conditions is acceptable. But stocks with a chequered history of dividend cuts and dips are best avoided.
Beyond dividends, a reliable income stream can only come from reliable companies. Ideally, they should be well-established and in an industry that’s likely to attract high demand for decades to come.
‘Boring’ insurers?
Take tobacco giant Imperial Brands for example. It has a great yield and a good payment record. But will tobacco still be an in-demand industry in 10 years? Possibly not. How about insurer M&G. Its 9.5% yield’s very attractive but it’s only been paying dividends for four years.
What about Legal & General (LSE: LGEN)? It has a 9% yield and an excellent track record of payments. It’s also a very well-established company with roots reaching back to 1863.
Now we’re talking!
It might be just a boring old insurance firm but that’s usually the type of business that’s reliable.
One risk is a £28.3bn debt load that’s not covered by cash flows or equity. This puts the company at risk of defaulting in the short term. Earnings have improved in the past year but if they start to drop again, dividends could be cut or reduced.
Like most dividend payers, it focuses on value rather than growth. As such, the share price has only increased 120% in the past 20 years. But that’s still an annualised return of 4%, which is better than nothing.
So if it maintained those returns, an investment of £8,000 could reach almost £100,000 in 20 years, with dividends reinvested. That would pay an annual dividend of £8,000 a year, of £667 a month.
It’s a long time to wait but a small price to pay for a decent income with minimal effort.
