Investing in dividend stocks can be a great way to generate passive income. My preferred strategy is to reinvest my dividends into more shares while holding my positions for years.
In doing so, I can benefit from compound returns — essentially the cumulative effect of stock market gains (or losses!) over time. Although it’s not a risk-free process, by taking a long-term approach to investing, I’m maximising my chances of securing a positive result.
With patience and dedication, I could eventually earn £20,000 in annual dividend income from investing just £5 a day. Here’s how.
Buying dividend shares
Saving a fiver a day equates to just over £152 a month. By using a commission-free broker like Freetrade, I can invest modest amounts on a monthly basis without worrying about incurring unnecessary fees.
The FTSE 100 index currently trades at a price-to-earnings (P/E) ratio of 8.8. Considering the average long-term multiple is in double figures, leading UK stocks appear to be trading at a discount on this valuation metric.
In fact, Britain’s biggest shares look particularly undervalued compared to many international benchmarks, like the S&P 500, which trade at premiums compared to their long-term averages.
Some major Footsie stocks look particularly attractive to me right now, both in terms of value and yield. Examples include:
| Stock | Dividend yield | P/E ratio |
|---|---|---|
| British American Tobacco | 9.0% | 9.0x |
| Glencore | 7.2% | 4.5x |
| Lloyds | 5.2% | 6.3x |
Although future returns could be attractive, any company can cut or suspend its distributions. That’s why I diversify my positions across different businesses and sectors, so I’m not overly reliant on any single stock.
Imagine I secured a 5% dividend yield across my portfolio and it grew at a 9% compound annual growth rate. Although this is a little above the average historic returns for the index, with some good stock picks I don’t think it’s overly ambitious.
By investing the equivalent of £5 a day, my portfolio would exceed £400k in less than 35 years. If I started at 30 and all went to plan, I’d be earning £20k in annual dividends by my 65th birthday!
Managing risk
Expecting dramatic results overnight is a mistake novice investors often make at the outset of their journeys. Granted, it’s possible to make quick returns from stocks. However, I’m a long-term investor, not a trader. Moreover, it’s worth remembering losses can accrue just as fast.
The stock market is a device which transfers money from the impatient to the patient.
Warren Buffett
Share price fluctuations mean stock market investors are adopting volatility risk. Essentially, there’s a possibility I may endure a run of poor returns immediately after investing.
My strategy tries to mitigate volatility risk. By adopting a long-term approach, I’m not preoccupying myself with short-term price movements. This reduces the temptation to sell if my stocks start sinking.
In addition, by investing smaller sums at regular intervals, I’m buying when prices are both high and low. This helps me to avoid overpaying for my preferred investments.
Plus, as I alluded to earlier, UK stocks look particularly cheap to me currently. And, over time, quality stocks tend to grow in value.
With that in mind, now’s the time for me to start buying dividend shares for passive income.
