The stock market can be an excellent source of passive income. It’s home to thousands of dividend shares that make regular payments to their shareholders.
But before I even start thinking about withdrawing dividends, I need to grow a sufficient pot of savings.
Let’s look at this a bit further.
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Quick passive income maths
Investing in shares is often regarded as a long-term activity. Rightly so, in my opinion. But while I own stocks that I intend to hold for many years, I also want to create an additional passive income far sooner.
Bear in mind that this isn’t a get-rich-quick thing. It will still likely take five years to set up. For instance, let’s say I invest £200 a month over five years.
My aim is to earn an additional £1,000 a year thereafter, with minimal time and effort. It’s not life-changing, but it can certainly contribute to my next holiday.
And if I want to target a larger sum, I could just raise my monthly investment.
So, to achieve this bonus income, I calculate that I’d need to build a pot worth around £14,300.
And to reach this figure, I know that my shares would need to earn 7% a year. As it happens, that’s around the average stock market return.
Dividend shares
Finding a selection of the highest-quality dividend shares would be my next task. While I’m building up my pot in the initial years, I’d avoid taking the dividends out. Instead, by reinvesting them and buying new shares, I could benefit from the magic of compounding.
This should help my pot to grow faster.
Once I’ve reached my target portfolio size, I’m ready to start withdrawing passive income in the form of dividends.
And as I’ve been investing in dividend shares from the start, I wouldn’t need to change my selection.
Quality stocks
When looking for the best dividend shares, the FTSE 100 is a great place to start. It’s home to several high-yielding stocks.
But I have to bear in mind that dividend yields that are far greater than average might not be sustainable. So it’s important that investors look for other characteristics like a history of consistent dividend payments, a solid balance sheet and growing earnings.
I’d also look for companies that operate a stable business model with strong competitive advantages. These might be less likely to be disrupted and could provide more stable earnings and dividends in the future.
Finally, I reckon it’s important to diversify and spread my selection across several industries. This should prevent me from putting all my eggs in one basket.
Stock selection
Right now, if I had a spare £200 a month to invest in this passive income plan, I’d buy Taylor Wimpey, Legal & General, Rio Tinto, Phoenix Group, and BP.
On average, this selection currently offers a 7% dividend yield. They all have a substantial payment history and their dividends are well-covered by earnings.
Lastly, they’re spread across different sectors. Just what I’m looking for.
