Dividend stocks continue to be one of the best ways to generate a passive income, in my opinion. It can take some time before this secondary income stream can become meaningful.
But even an extra couple hundred pounds in the bank each month can be a tremendous help in achieving a more comfortable lifestyle, whether that’s eating out more often, or helping to save for a holiday.
So if I had £500 spare each month from my salary and I was looking to establish a £200 monthly income stream, how would I go about it? And, more importantly, how long would it take? Let’s explore.
Calculating milestones and timelines
Since my goal is to generate a passive income purely from dividends rather than any capital gains, my primary focus is on maximising my portfolio yield while minimising risk.
There’s always a sweet spot when it comes to risk versus return and, in my experience, a yield of around 5% seems to be close to it.
Generating £200 a month is equivalent to £2,400 a year. And assuming I can build a 5%-yielding portfolio, that means I’d need to have around £48,000 at hand.
Obviously, I’m not going to find that down the back of the sofa. However, by drip-feeding my spare £500 each month into top-notch stocks and reinvesting any dividends received, it’s possible to build up to this threshold.
When looking at the FTSE 100, the leading dividend stocks in the UK generate an average annualised return of around 8%. And assuming I can replicate this performance, it would take just over six years to hit my goal, and about 10 years to double it when starting from zero.
But it’s important to note that shares can go up as well as down. And should the stock market decide to throw a tantrum along the way, then even the best portfolio could take longer than expected to reach £48,000.
Finding the right stocks
The UK’s flagship index currently offers a dividend yield of around 3.8%. That’s not bad. But if I’m aiming for 5%, then I’m going to have to be more selective about which businesses I add to my portfolio versus an index fund.
Stock picking is a challenging skill to master. And depending on the objective, the approach required can vary widely. When it comes to income stocks, my focus immediately goes to cash flow.
Since dividends are ultimately funded by excess cash generated from operations, it’s critical to ensure that the underlying business is capable of maintaining and growing shareholder payouts.
I’m also weary of overleveraged balance sheets since debt and interest payments take priority over dividends. And with interest rates being hiked aggressively, high debt burdens could hamper shareholder income potential.
