Is it realistic to try and set up a second income without taking on an additional job? I think it is and I try to do just that by investing in dividend shares.
I like that approach because it can help me profit from the success of large companies such as J Sainsbury and HSBC that have tens of thousands of full-time employees working hard across the year. Here is how I would put such an approach into action with a target of earning £10,000 in dividend income annually.
Future dividend payers
As dividend shares are core to my plan, I would need to choose which ones to buy. As a long-term investor I would be planning to hold these shares for years, not jump in and out of them regularly. So I would want to make sure I felt confident about the quality of the shares I was buying.
Dividends are basically how a company distributes spare cash it generates that is surplus to requirements.
So I would want to find businesses that I expect to throw off a lot of spare cash in future. Often such firms have a large potential customer base and something that can offer them a competitive advantage, whether it is patents like AstraZeneca has or a proprietary distribution network like National Grid‘s.
But remember I am looking for cash that could be surplus to requirements. That rules out companies like Berkshire Hathaway. It generates a lot of free cash flow. But its boss Warren Buffett likes to use that money to make acquisitions now or save it for future use. So Berkshire, like a lot of companies, does not pay dividends even though it generates substantial amounts of cash.
Balancing my portfolio
What Buffett does do, though, is diversify his risks by investing in a range of companies.
That way, if one of them disappoints him – like an investment in Tesco did in 2014 – the impact on his overall investment returns will be limited.
I think that makes sense for me when choosing dividend shares for my own portfolio.
Hitting my target
But how will I know if £10,000 of passive income annually is within reach for me when using such an approach?
My expected dividend income reflects how much I invest and what is known as the average dividend yield of the shares in my portfolio. So if I am earning a 5% yield, for example, earning £10,000 each year would require me to invest £200,000 in total. A 10% yield, by contrast, would require the smaller amount of £100,000 to be invested.
I would not simply chase the highest yield though. Sometimes an unusually high yield can be a red flag that the City expects a company to reduce its dividend. Instead, I would focus on finding great companies at attractive prices in the way I described above. That is also the approach Buffett uses, incidentally.
Even if I had a far more modest amount to invest, I could still start using the above approach. I would simply start on a smaller scale and build up to the £10,000 target over the course of several years. Reinvesting the income from my dividend shares as I go – something known as compounding – could help me get there sooner.
