Earning a passive income has obvious appeal. After all, who doesn’t like the idea of making money without having to lift a finger? But most traditional methods of achieving this financial goal, such as starting a business, or buying a rental property, require a lot of initial capital to get the ball rolling.
Fortunately, that’s not the case with dividend shares. And even putting aside just £5 a day is enough to start building a lucrative income stream from an investment portfolio. So for investors looking to establish a lifelong passive income, here are the main steps involved.
How to start
To start receiving dividends, the first step is to buy and hold dividend-paying shares. This is done through a brokerage account. And for British investors, leveraging the power of a Stocks and Shares ISA can provide significant tax benefits.
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However, buying stocks isn’t free, and commission charges can quickly eat into capital when trading too frequently. So suppose an individual is putting aside £5 a day for investments. In that case, depositing this money into an interest-bearing savings account is typically smarter until it becomes a more substantial lump sum.
After one year at this savings rate, there will be roughly £1,825 available to buy shares, which is more than enough to start building an investment portfolio. However, there’s still a long way to go until a significant passive income stream can be established.
The average dividend yield for the London Stock Exchange is around 4%. By hand-selecting top-notch income stocks, achieving a yield closer to 5% is possible without taking too much additional risk. However, 5% of £1,825 is only £91.25. While nice to have, it’s definitely not enough to replace a salary. But, given time, it could be.
Including capital gains on investments, the stock market has historically provided an average annual return of around 10%. By reinvesting dividends and regularly saving additional capital each year, compounding can do its magic. And with enough time, investors can establish impressive passive income streams that can help unlock a more comfortable lifestyle, even when starting from scratch.
| Year | Portfolio Value | Estimated Passive Income |
|---|---|---|
| 1 | £1,911 | £95.55 |
| 5 | £11,777 | £588.85 |
| 10 | £31,153 | £1,557.65 |
| 20 | £115,487 | £5,774.35 |
| 30 | £343,782 | £17,189.10 |
| 40 | £961,785 | £48,089.25 |
Investing has risks
As marvellous as dividends are, they’re far from guaranteed. Don’t forget that these payments are optional for businesses and are used solely as a mechanism for redistributing excess capital back to shareholders. A firm whose cash flow becomes disrupted will likely cut, or suspend, future payments cutting off an investor’s passive income at the source.
This risk will always be present, even among businesses with outstanding track records offering impressive payouts. But there’s also the general market risk to consider. As 2022 unkindly reminded everyone, corrections and crashes occasionally come along to throw a spanner in the works. And these unpleasant events, while temporary, can significantly impact the value of an investment portfolio.
Having said that, these risks can be mitigated. And a prudently-managed portfolio of hand-picked, high-quality enterprises can provide a substantial stream of passive income, even when investing just £5 a day.
