Dividend shares can be a useful source of passive income. When big companies like Shell, Unilever and Lloyds make profits, they often use some of them to make a payout to shareholders.
Such payouts are never guaranteed. Indeed, two of that trio of firms have reduced or cancelled the dividend at some point over the past five years.
However, with careful share selection and the use of risk management techniques like diversification, it should be possible to aim for sizeable passive income streams in the form of dividends.
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If I had a spare £10,000 to invest, that would comfortably let me diversify across five to 10 blue-chip dividend shares.
With some tempting bargains in the stock market right now, I reckon I could realistically aim for a four-figure annual passive income by doing that. Here’s how.
Hitting a target yield
To earn £1,000 in passive income from a £10,000 investment, I would need to earn an average dividend yield of 10%.
That might sound improbably high. But some corners of today’s stock market offer what I see as cheap high-yield shares. Even within the FTSE 100 index of leading firms, for example, we have Vodafone and its 11.7% yield and 10%-yielding Phoenix.
But I am not limited to the FTSE 100. I could buy other shares.
Take investment trusts as an example. From the 16% offered by Income and Growth Venture Capital Trust to Henderson Far East Income and its 11.6% yield, quite a few high-yield investment trusts have caught my attention.
One caveat is key though. Buying a share just for its yield can end up being a crashing – and costly – disappointment. As dividends are never guaranteed, they can be cut. That may also lead to the share price tumbling, meaning if I sell my shares I may get back less than I paid for them.
Building a £1,000 annual passive income
Still, while not all high-yield shares would make my shopping list, some would. For example, I have bought into Vodafone this year.
If not looking at yield though, how might I select what dividend shares could merit a place in my portfolio?
Basically, I take the same approach to shares whether I see them as offering the prospect of income, growth, or both. I start by looking for a business I understand that I think has a sustainable competitive advantage in a market I expect to benefit from resilient customer demand.
I then consider the price at which a share is selling. That is important for dividend shares as well as growth shares, in my view.
After all, if I overpay for a share then I may not even get back what I paid for it if I decide to sell in future. If I overpay for a share and it then cuts its dividend, I could end up not earning what I hoped for in income but also being unable to sell for as high a price as I paid.
Fortunately, I think that right now there are some cheap-looking shares in great companies that offer very juicy dividend yields.
