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How to pick dividend shares for extra income

Though it is a long forgotten memory, there was a time when banks were forced to offer interest rates above 10% on simple saving accounts. Of course, the similarly high levels of interest charged on credit cards, loans, and mortgages more than offset any benefit these rates brought to consumers, but anyone who has attempted to find a decent savings account in recent years will see these numbers as unimaginable.

Looking at dividend yields for UK shares, however, shows a different story, though maybe not quite up to the 10% level. In the UK today, it is perfectly possible to invest in strong, blue-chip stocks that offer returns of 4%, 5%, and 6%. The problem, of course, is making sure you pick the right stocks.

No guaranteed returns

The major disadvantage shares have over savings accounts is that your principle is not guaranteed to be returned. You can lose money as well as make it, whereas with bank accounts the cash is always there for you to access.

Well, this isn’t strictly true – savings in a bank have some guarantee by the UK government, but at least in theory both the bank and the government could go bust (think of Greece in the financial crisis, or the run on Northern Rock) – but it is fair to say your chance of losing money in a savings account is extremely low. However, your chance of losing purchasing power can be high, as inflation is running higher than savings account interest rates at the moment.

There is always a higher chance of losing money on shares, which is why you need to pick carefully, and invest for the long term. If income is your only concern, you should aim to buy a strong, well-established, blue-chip company, in an industry that is set to endure for the foreseeable future, safe, and perhaps growing. The price of the stock will no doubt go up and down, but unless you sell the shares, the profit or loss is only on paper. The dividends meanwhile, will keep paying off.

Expected returns

After hopefully ensuring your principle is safe in the long run, the next major consideration is of course, what returns you can get. My rule of thumb for income stocks has always been to look for a yield between 4% and 6%. Anything more and it usually signifies the company is paying too much for one reason or another.

Unlike bonds, which (again, in theory) offer a fixed income, dividends are not fixed. Just as though you were the owner of a firm, they are in fact a share of a company’s profits allocated based on how much of the firm you own (number of shares).

This means that for a long-term income, you want to have seen consistent dividend growth from the company over a decent period of time – say five years.

To help ensure your principle further, you should aim to divide your money between perhaps up to ten firms, across different sectors, diversifying your portfolio to project against shocks to any one company or industry.

Key takeaways

  • Pick strong, well-established, blue-chip firms.
  • Aim to invest in 5 to 10 companies, across sectors, for a diverse portfolio.
  • Plan to invest for at least 5 years.
  • Aim for dividend yields between 4% and 6%.
  • Look for consistent and strong dividend growth over the past 5 years.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.