Work more hours to earn more money? I could do that, as a way to try and build a second income. But an alternative approach is to let others do the hard work while I benefit financially.
One way to try and achieve that is by investing in dividend-paying shares. Indeed, I use that approach at the moment, alongside millions of other investors.
One thing I like about this method is that I can match it to my own circumstances. Investing in shares does not require me to have a lot of money upfront, unlike some second income ideas. But if I only put aside, say £20 a week, how realistic is it that I could build a meaningful extra income stream?
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Long-term investing
The answer is that it is realistic, but I need to be patient. This is a long-term project. Basically, my future returns from such an approach will boil down to three elements.
First, how much capital am I investing? Saving £20 a week adds up to £1,040 per year that I can put into the stock market.
Secondly, what is the average dividend yield of the shares I buy? Yield is the percentage of my cost I expect to get back each year in dividends, which will form the backbone of my second income.
Dividends are never guaranteed – Direct Line axed its shareholder payout altogether this year, for example. But if I invest £1,040 in shares that yield an average 5%, that ought to earn me £52 per year in dividends.
Finally, I also need to consider capital gain, or loss. In other words, if I buy shares at one price and later sell them at a higher price, I could make money on top of any dividends. If they fall in value, on the other hand, I may not get back all of the money I originally invested.
Building an investment strategy
That throws up a couple of considerations when building my investment strategy. For example, should I compound the dividends?
Compounding means reinvesting dividends, rather than taking them as cash. That would mean delaying my second income in the hope of making it bigger in future.
In my example, £1,040 invested at a 5% yield would earn me £52 per year. If I reinvest my dividends for a decade at a compound annual growth rate of 5%, after 10 years that same £1,040 ought to be earning me £85 per year.
Another point for me to consider is how to strike the right balance between yield and risk. Just because a share has a high yield now does not mean it will earn me more second income over the long run.
The dividend could be cut, or completely axed, like in the Direct Line example. That is why I diversify my portfolio across a number of shares. But it also explains why I do not choose shares just because of their yield. Instead, I aim to buy into high-quality businesses selling at attractive prices.
After a decade, investing £20 a week and compounding at 5% annually, I ought to be earning about £655 each year in dividends. That is closer to some handy extra cash than a substantial second income — but it could help me earn even more over time.
