One of my favourite ways to earn passive income is by owning dividend shares. Receiving a chunk of company profits in the form of dividends sounds appealing, as I can let companies do all of the heavy lifting for me.
Once I’ve made my purchases, I can sit back and watch those quarterly payments roll in. It would be great if that was all, but there are a few points to consider.
What I’d look for in stocks
First, companies pay dividends from earnings. So investors would need to find dividend stocks that are likely to grow their income over time. I’d focus on solid, established and profitable business models.
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I’d also concentrate on areas that benefit from strong underlying trends like population growth and healthcare.
Although the dividend yield is important, I’d also look for consistent payment history and dividend growth. With several FTSE 100 shares currently offering over 8%, there’s no shortage of potential shares I could buy.
Supersizing passive income
The good thing about dividend investing is that it’s possible to start with a relatively modest sum. Even just £5 a day is enough to get started. That amounts to £1,825 a year.
With that I could buy a bunch of dividend shares and start receiving quarterly payments shortly thereafter. But I wouldn’t do that just yet.
Instead, I’d reinvest them to buy more shares. That way, I’d not only earn dividends on the original shares, but also on these new ones.
By continuing this process, my investment should grow in a snowball effect. It’s called compounding, and Albert Einstein famously referred to it as the eighth wonder of the world.
I’d also continue investing £5 a day, or £1,825 a year. By delaying when I cash in my dividends to spend on treats, my total pot should grow larger over time.
Let’s take a look what the effect of this could be:
| Years invested | Total investment pot | Passive income per year |
| 10 | £26,437 | £2,115 |
| 20 | £83,515 | £6,681 |
| 30 | £206,741 | £16,539 |
Assuming that I can continue to earn an 8% dividend yield, the total investment pot and annual passive income should expand as above.
8% dividend yield
Next, let’s turn to which stocks to buy to achieve an 8% dividend yield. If I didn’t already own enough dividend stocks, I’d buy Phoenix Group, Legal & General, Imperial Brands, NatWest and SSE.
This selection averages 8% and is spread across different industry groups. With an average dividend history of over 20 years, it shows management’s policy towards distributing cash to shareholders.
But in addition to looking at the past, I’d need to keep an eye on the present. Even established businesses can be affected by change. For instance, new competition or regulation can change a company’s prospects and future profits.
That said, right now I’m happy with how these shares are faring. And if that changes, I’m confident there will be many others to replace them. Either way, I’d expect my passive income plan to reap dividends.
