The idea of earning a second income by owning dividend shares is not new or radical – but it can be financially lucrative.
If someone wanted to target an average £1,000 monthly second income buying dividend shares, here are three possible approaches they could take.
Approach 1: invest in a top index tracker fund
£1,000 a month adds up to £12k in a year. At the moment, the FTSE 100 index of leading companies yields around 3.4%. So to hit that target immediately, someone could invest around £353k into a FTSE 100 tracker fund.
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Most people do not have a spare £353k and even if they did, they may prefer not to invest it all at once, but instead utilise their annual allowance over time in a Stocks and Shares ISA.
This approach does have some possible advantages though. The second income could start flowing within months and it would be generated by a broad-based basket of blue-chip businesses.
A range of index trackers is on offer. It would make sense to compare them, as they may charge in different ways for monthly income withdrawals.
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Approach 2: drip feed money into blue-chip shares
Another approach is to start from zero and invest an affordable amount monthly into an ISA or share-dealing account.
No dividend is ever guaranteed, but I see value in sticking to blue-chip shares with proven businesses. Rather than just tracking the FTSE 100 though, an investor could buy a diversified portfolio of selected individual shares. Doing that, I think it is possible to target a 7% yield in the current market.
One share investors could consider is British American Tobacco (LSE: BATS). The owner of brands including Lucky Strike has a highly cash generative business that helps fund a big dividend. The dividend per share has grown annually for decades and the current yield is 7.4%.
British American has a strong brand portfolio, proven business model and large customer base. However, I do see risks. Cigarette sales are declining in many markets, eating into revenues and profits. Non-cigarette products like vapes may replace some of those sales volumes. But that remains to be seen — and how profitable they will be over the long run.
Still, the cigarette market remains substantial and I expect it will be around for a good while yet. British American has proven able to generate lots of excess cash and willing to divvy it up among shareholders.
If an investor put £500 a month into blue-chip shares yielding an average 7%, their second income hopefully ought to grow annually and within 29 years they should be earning £1k each month.
Approach 3: unleash the financial power of compounding dividends
That 29-year wait to hit the target could be cut to just 16 years using the same approach — with one difference. Rather than taking out the dividends along the way, an investor putting in the same £500 each month at an average 7% yield could initially reinvest the dividends.
Then, once the portfolio was big enough (after 16 years), they could start receiving the dividends as a second income. This approach is known as compounding – and is a simple way to try and grow a sizeable second income from dividend shares faster.
