There are lots of different ways to try and build a second income. Fortunately, not all of them involve stretching an already long working day even further.
For example, one common approach is to buy a range of blue-chip shares that pay out some spare cash to shareholders as dividends.
Here’s how £20,000 could be used to target a second income of more than £9,000 over the long term using that approach.
Some pros and cons of dividends
That basically sounds like free money — and who would not be happy getting free money instead of labouring hard for a second income?
I see some other advantages of buying dividend shares as a second income generation strategy.
It need not be complicated and it can also result in capital gain if those shares rise in value over time (though they could also lose value, regardless of what happens with their dividends).
One potential downside is that dividends are never guaranteed. Shell had not cut its dividend since the war, then shocked shareholders in 2020 by doing just that.
Setting up for success
Still, there are some steps that could help mitigate some risks.
One is diversifying across different shares. £20k is ample for that.
Another is careful selection of shares based not just on past dividends (remember – they are never guaranteed to keep coming), but rather on what you reckon a business looks capable of generating in future.
£20k could also slot neatly into one year’s ISA contribution allowance. That could mean, for many investors at least, the dividends pile up inside the ISA over the long term without being taxed.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Taking the long-term approach to investing
But wait – what is this about dividends piling up over the long term? After all, I said the point of this approach was to generate a second income.
Yes it is. But taking time to do that can improve the size of that income dramatically.
How much an ISA generates in dividend depends on its size and the average dividend yield of the investments in it. Dividend yield is basically what an investor earns annually in dividends, expressed as a percentage of the portfolio cost.
So, a 7.5% yield on £20,000 would generate a £1,500 second income annually.
But reinvesting those dividends (known as compounding), after 25 years the larger portfolio size would mean a 7.5% yield equated to an annual second income of £9.148.
ISA costs can eat into the annual return, so it makes sense to compare different Stocks and Shares ISAs.
Finding shares to buy
A 7.5% yield is over twice the FTSE 100 average.
One share I think a second income hunter should consider as part of a diversified portfolio is 7.3%-yielding British American Tobacco (LSE: BATS).
Tobacco is a highly cash generative industry, thanks to low manufacturing costs, a captive market, and high selling prices. British American’s premium brand portfolio helps it too.
One risk I see to future free cash flows is declining demand for cigarettes. British American has been building its non-cigarette portfolio, but for now that remains nowhere near the profitability of cigarettes.
The company has raised its dividend per share each year this century. That is no guarantee of future dividends, but it is indicative of how powerful the business model can be.
