Putting under £50 a week into cheap dividend shares and reinvesting the proceeds over time is one way to build a passive income. Potentially, a big passive income.
Here, I explain how someone could aim to do just that.
Here’s how the money adds up
Imagine the money’s invested at an average dividend yield of 7% (I’ll get into that below). Putting £200 a month into shares and compounding them annually at 7%, after 20 years (in 2045) the portfolio would be worth around £101,545.
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At a yield of 7%, that would be enough to throw off £7,108 of passive income the following year. In fact, it could potentially do that every year afterwards. The amount may actually go up, although it could also go down, depending on whether dividends are maintained, raised, or cut.
Buying cheap shares can be an income booster
That explains why the smart investor would diversify across a range of shares rather than put all their eggs in one basket.
Another part of this plan is buying cheap shares. When it comes to dividend income, cheap shares can be a bargain.
Here is why. At the moment, the average yield for blue-chip FTSE 100 shares is 3.6%. So the target 7% yield I am discussing here is fairly aggressive.
But buying dividend shares when they sell for a cheap price means the yield is higher than buying the shame shares more expensively.
Hunting for bargain shares to buy
For example, Lloyds (LSE: LLOY) shares yield 4.5% at the moment. Not bad at all.
The Lloyds share price has risen 54% over the past year. So not only would someone who invested in the Black Horse Bank back then now be sitting on a very tidy paper profit, they would also be earning a yield of around 6.8% compared to the lower 4.5% yield available to investors buying today.
Is there a way to spot a cheap share versus a value trap? Not one that is guaranteed to work, or else the smart money would all be used the same way in the market.
But Lloyds obviously has a lot going for it. It has a massive mortgage book, large customer base and multiple well-known brands in the UK market.
One reason for that 54% share price rise over the past year seems to be that investors are now less concerned than before about the risk an economic slowdown could push up loan default rates and eat into Lloyds’ profits.
That risk still concerns me though. I am unsure that Lloyds is indeed a cheap share and not one that will ultimately turn out to be a value trap. So I have not bought its shares.
Getting the ball rolling on the income machine
Still, I do think there are plenty of cheap shares in today’s market even among blue-chips.
Indeed, shares I own, including Legal & General and M&G, yield even more than 7% at their current share prices.
The passive income plan I outlined above is not complicated, but it will not happen by itself.
To get going immediately, I think a new investor could look at some of the share-dealing accounts and Stocks and Shares ISAs available to see what looks most attractive.
