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How to supplement income with dividends

With today’s low interest rates, traditional passive savings like bank accounts and government bonds simply don’t offer enough returns for many of us to supplement our income.

Though shares have often seemed a riskier prospect to some people, I think with sensible decision-making, realistic expectations, and enough capital, investing in dividend stocks could be the best way to get extra income.

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Risk profile

The first thing to consider is your appetite for risk. As a general rule, if you are entirely focused on income as your main investment goal, you should be looking towards buying stocks that should lose little or no value in the long run (and preferably grow).

This inevitably means focusing on the major blue-chip companies, with strong brands, in industries you expect to have no major disruptions in the years you hold the shares. While these stocks are less likely to massively increase your capital, they are also less likely to lose you much as well – the classic risk-reward trade-off.

Generally it is also recommended you invest in shares for a minimum of five years. In this time, short-term fluctuations in their prices should even out. You should also aim to create a portfolio of income producing stocks, rather than investing all your money in just one share.

Again this lowers the overall risk to your capital (as well as reducing the potential for large capital gains), but with income as your goal it is easy enough to find a number of shares that match your dividend criteria. Holding ten stocks is a good, rough guide to how large an income portfolio should be.

Show me the money

With these conditions put in place, the main consideration is of course, how much return you can expect. Dividends are paid in pence-per-share, and for comparison purposes are usually converted into a percentage – the dividend yield figure. In my experience a yield of 4% to 6% is the best range to look for.

Anything below 4% is on the low side for an income investment, while anything above 6% sends up red flags for me as to why a company is offering such a high yield (often to entice investors to ignore other worrying signs).

There are some exceptions to this high end figure, however, as occasionally speculation can bring a share price down low enough to make it offer a higher yield, even though the company is fundamentally sound. These are worth looking for, but if in doubt stick to the 4%–6% Goldilocks zone.

The final consideration is what is called dividend growth. Unlike bonds, for example, which have a fixed income at the time you invest, dividends are in fact a share of a company’s profits, and so can vary year to year.

Investing only in strong blue chips should help on this front, as one would hope they are consistently profitable (or at least able to withstand lean years), but I would also look for consistent dividend payments and a nice level of dividend growth, say over the past five years.

With this in mind, investing in ten shares with dividends ranging from 4%–6%, it should be easy to have an average return on your investment of 5%. How you use this income, I leave to you.

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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.