One way lots of people earn passive income is by investing in shares that pay dividends.
Even starting from zero on a small budget, doing that regularly could lead to sizeable passive income streams over the long term.
How significant? That largely depends on three key questions: how much is invested, at what average annual return and for how long?
Earning money without working for it
For example, imagine somebody invests £5 a day at a 5% compound annual growth rate. After a decade the portfolio should be worth over £23k. At a 5% dividend yield, that could generate £1,174 in passive income generally.
Waiting for 20 years though, the equivalent numbers would be over £61k and £3,086 respectively. Note that the amount earned more than doubles by doubling the timeframe. That’s because of the power of compounding, dividends earned themselves start to earn dividends.
Setting realistic goals
Dividends are never guaranteed to last though – even if a company has been a regular payer to date. So building a diversified portfolio of blue-chip shares involves carefully considering their future prospects, not only looking at their past performance.
How realistic is the 5% compound annual growth rate I used in the example above? I reckon it is pretty realistic. The current average FTSE 100 yield is 3.3%, but some shares offer yields well above that.
The compound annual growth rate consists not only of any dividends paid, but also share price growth. It can be negatively affected by declining share prices too.
Putting in more money could boost the passive income streams, as could taking a longer timeframe than in my example. So too could earning more than 5% but I think its important always to focus on the quality of a share when considering it.
Another factor that can eat into returns is fees, charges and commissions. So I think an investor ought to look around when considering their options for buying shares, whether through a dealing account, Stocks and Shares ISA or trading app.
On the hunt for the right kind of shares
One share I think investors should consider for passive income is City of London Investment Trust (LSE: CTY). The trust has a dividend yield of 4.4%. It has a run of annual dividend per share increases stretching back to the 1960s. Few shares in the London market can match such a performance when it comes to uninterrupted annual dividend per share growth.
Whether that lasts remains to be seen. But the trust’s strategy of investing in large companies and its British focus strikes me as a fairly conservative but potentially lucrative approach over the long term.
It ties City of London’s fortunes to those of the UK economy to a large extent and there is a risk that current economic sluggishness could affect City of London’s performance.
However, that will also depend on specifically what shares the trust managers decide to invest in. They have been able to increase the trust’s value over time, as well as paying out regular dividends, thanks to their approach. I am hopeful that that will continue to be true.
