What’s your favourite passive income idea? While some people may dabble with dropshipping or setting up an online business, for many the passive income idea that actually earns them money is an old one: owning shares that pay dividends.
That can be a lucrative approach to generating money without having to work hard for it. To illustrate, let’s imagine somebody has a spare £5k they want to invest.
Choosing a suitable investment vehicle
The first step will be putting that money somewhere it can be used to buy and hold shares that hopefully will earn dividends. That may be a share-dealing account, Stocks and Shares ISA or trading app, for example.
Lots of different options exists and different investors have different priorities, so it is important to take some time and compare choices.
Buying a diversified range of blue-chip shares
The money can then be put inside the vehicle. Once the investor feels confident that they understand at least basics of stock market investing such as how to value shares and what allows a company to fund dividends, they can start to buy dividend shares.
Even the best companies could run into difficulties. A simple way to reduce the risk if one share does that is to diversify across a few different choices and £5k is ample for that.
As dividends are never guaranteed to last, it is important to look carefully at companies and consider not only their current business performance but also their future prospects, as well as how accurately today’s share price reflects that.
My own focus tends to be on investing in proven companies that have shown their business model works. Lots of blue-chip shares that make profits and pay dividends can provide a fertile hunting ground.
Earning the income
How much £5k might generate in passive income depends both the dividend yield and timeframe. Yield is what the shares pay annually in dividends, expressed as a percentage of their purchase price.
Currently the FTSE 100 yields around 3% but I think a 6% yield is an achievable target in the current market. On £5k, that would mean some £300 a year of passive income.
But an investor might decide to reinvest dividends. This is known as compounding and can be a financial force multiplier. Compounding £5k at 6% for 10 years, for example, it would grow large enough to earn around £537 of passive income each year.
Or, if someone was willing to wait for 20 years before drawing down the dividends, compounding could help them reach a point where they earn £962 of passive income annually.
One income share to consider
I think a dividend share investors should consider is M&G (LSE: MNG). The FTSE 100 asset manager aims to raise its dividend per share annually. That is not guaranteed, but M&G has managed in recent years. It yields an attractive 6.8% right now.
There are risks. With millions of customers spread across multiple markets, M&G could see some pulling out funds amid market choppiness like we are seeing this year. That could hurt profits – and perhaps dividends.
But I see that large customer base as an asset. The company has a strong brand and deep asset management expertise. It is also a proven cash generator. That bodes well for future dividends.
