Earning a second income from the stock market is a key objective for many investors, including me. With the ability to earn tax-free capital gains and dividends from a Stocks and Shares ISA, I think it’s possible to achieve this ambition by pursuing a long-term investing strategy.
But how much would I need to invest to earn £20,000 in annual dividend income? And how long would it take to build a big enough portfolio? Let’s crunch the numbers.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
What’s more, today we’re giving away one of these stock picks, absolutely free!
Buying dividend stocks
With passive income as a priority, I’m looking for dividend shares.
The average dividend yield for FTSE 100 stocks is currently 3.8%. However, some sectors are renowned for high-yield dividend stocks. These include tobacco, banking and housebuilding, among others.
Examples of FTSE 100 shares that feature in my portfolio are:
- British American Tobacco — 9% yield
- Lloyds Bank — 5.4% yield
- Taylor Wimpey — 8.2% yield
With a £20k annual passive income goal, there are two key numbers for my modelling assumptions to ascertain how much I need to invest and how long the journey will take.
Dividend yield
First, there’s my target dividend yield. Essentially, this is the average yield across my stocks. Variations in the yield can produce very different numbers in terms of my required portfolio value.
To illustrate this, here’s the amount I’d need to invest to earn a £20k second income from a range of yields.
| Dividend yield | Portfolio value required |
|---|---|
| 3% | £666,667 |
| 4% | £500,000 |
| 5% | £400,000 |
| 6% | £333,333 |
| 7% | £285,714 |
Compound returns
Second, I need to focus on my portfolio’s compound annual growth rate (CAGR). Essentially, this figure is the percentage increase in the value of my shareholdings from ISA contributions, share price appreciation and dividends reinvested.
For instance, if I aimed for a 5% average yield, I’d need a £400k portfolio. Let’s assume I saved and invested £10 a day. Here’s how long I’d need to hit my target at different rates of return.
| CAGR | Time taken |
|---|---|
| 3% | 48 years, six months |
| 4% | 42 years, one month |
| 5% | 37 years, four months |
| 6% | 33 years, nine months |
| 7% | 30 years, 10 months |
So it’s clear the amount I’d need to invest for a £20k second income varies enormously depending on my average yield and my portfolio’s CAGR over time.
For example, if I invested £10 a day, stuck with a 5% target yield and my portfolio’s CAGR was 7%, I could invest £112,847 to hit my target £400k value in under 31 years.
Conversely, at a 3% CAGR, I’d need to invest £177,331 over a whopping 48.5 years to reach my goal! That’s an extra £64,484 and 17 years, eight months.
Managing risks
Dividend investing isn’t risk-free. Underwhelming returns resulting from bear markets or poor stock picks could mean my investing journey would take an incredibly long time. Or even require larger regular ISA contributions, as the above numbers demonstrate.
In addition, if companies cut or suspended their dividends, my required portfolio value would increase, as my average yield would drop.
However, via diversification and reliable dividend stock picks, it’s possible to unleash the enormous potential of compound returns. Which means I could generate a £20k second income in a reasonable timeframe for as little as a tenner a day.
