Passive income is money one receives without working for it. Passive income isn’t necessarily about funding a luxurious lifestyle of beach holidays and Ferraris. It can be as simple as a little more money each month to help pay a mobile phone bill or cover a fancy meal out with a loved one.
Here’s how I would plan to make £90 a month in passive income, by investing in dividend shares.
What are dividend shares?
Shares are effectively fractions of a company. When I buy a share, I basically own a tiny bit of that company.
If the company generates profits, it can choose to distribute them as dividends. That doesn’t always happen. Companies may keep some funds back to use in their business. But dividend shares are ones that often pay out dividends. Dividends are never guaranteed, which is one reason I try to diversify my portfolio across a variety of shares and business sectors.
Dividend shares as passive income
I like dividend shares as a form of passive income. Unlike some passive income ideas, there really is little effort involved for me. Once I buy a share, I can sit back and watch the money come in when dividends are paid. I don’t have to set up an online shop. I don’t have to find customers. I don’t have to chase unpaid invoices.
Unlike some passive income sources, though, I can’t start earning passive income with no money upfront. To buy dividend shares for passive income, I’ll need to have some money. This can be a lump sum, or it could be something I build up over time by putting a little money each month into a Stocks and Shares ISA.
Doing the maths
How much would I need to invest to try and generate £90 a month in passive income?
That depends how much the shares I buy ‘yield’ – in other words, what percentage of the share price the dividend represents. If I buy shares with a yield of 1%, I’d need to invest £108,000 to generate £90 in monthly passive income. But if the shares yield 5%, I’d only need £21,600.
Higher yields aren’t necessarily better, though. They can also be a danger signal that the market is worried a company’s payout level is unsustainable, for example, due to future profit declines. I never buy shares based on yield alone. I do some research to help me understand a company’s future prospects.
Choosing the passive income ideas
I’d try to reduce my risk by diversifying my share picks. But I would focus firmly on dividends. So, for example, there may be shares I think have growth prospects but don’t pay dividends. For passive income, I wouldn’t buy them.
By contrast, I’d be willing to invest in companies that I think have limited growth prospects, such as National Grid and Imperial Brands, because of their attractive dividend yields. Using the average yield of 5% example above, I’d be looking to buy less than £22,000 worth of shares. I’d split the money between at least five business sectors for diversification, and choose no more than two companies in any one sector. Here’s an example of a passive income portfolio I could build on that basis.
Christopher Ruane owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands and National Grid. 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.