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How I’d invest £250 a month to make a £20,000 passive income from dividend shares

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Even though the stock market rally has caused many dividend shares to trade at higher prices, many UK stocks offer good value for money. Buying a wide range of them on a regular basis could produce a surprisingly large retirement nest egg that provides a generous passive income in older age.

Through identifying good value companies and holding them for the long run, an investor could realistically double their State Pension to achieve financial freedom with a modest monthly investment.

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Investing in good value dividend shares

While some dividend shares are still cheap after the 2020 stock market crash, not all of them may be worth buying. After all, some businesses have relatively weak balance sheets following a decade of global economic growth that caused them to take higher risks.

As such, it’s important to focus on the quality of a company alongside its price level. In doing so, an investor can buy high-quality companies while they trade at low prices. Certainly, they may face challenging operating conditions in the short run.

However, their financial strength and market position is likely to allow them to overcome such threats. Furthermore, a difficult near-term outlook is unlikely to last in perpetuity, with it providing buying opportunities in the short run.

Scarce passive income opportunities

Dividend shares could become increasingly attractive to a wide range of investors over the coming years. After all, a period of low interest rates looks set to be a feature of investing over the next few years. Certainly as policymakers may prioritise economic growth over low inflation.

This may mean demand for income shares rises. Especially as high house prices limit yields in many parts of the UK’s property markets. Along with cash and bonds, property may be unattractive compared to dividend shares.

An investor could obtain the same return as the FTSE 250 has managed over the past 20 years of around 8.5%. That way it would be possible to build a large passive income in the long run. For example, investing £250 per month at an 8.5% annual rate of return would produce a portfolio valued at £650,000 within 35 years. From that, a 3.5% annual withdrawal would mean an annual income of around £22,750.

Maximising returns in a stock market rally

Of course, dividend shares that can grow their shareholder payouts at a fast pace may become even more valuable over the long run. As such, buying dividend stocks that pay out a relatively modest proportion of net profit to shareholders may have greater scope to raise dividends over the coming years.

Similarly, companies that are likely to benefit from industry-wide growth trends may deliver rising dividends. They could become more popular among a broader range of investors, thereby producing higher levels of total returns that have a positive impact on an investor’s passive income in retirement.

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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.

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