Investing in shares that pay dividends is a common, practical way for people to earn passive income.
That does not mean it is easy. Dividends are never guaranteed and share prices can fall, so a smart investing approach matters. But without much effort, I think a realistic and sensible investor could build substantial passive income streams over time.
As an example, with a spare £20k, here is what an investor might be able to achieve while sticking to proven blue-chip companies from the top tier FTSE 100 index.
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Investing smartly and realistically
Twenty grand is a good amount actually, as it easily allows an investor to diversify across a few different shares. That is a simple but important risk management principle and £20k could also typically be invested as one year’s ISA allowance. This year’s contribution deadline is just a fortnight away.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
I think an investor would do well to follow other principles of good investment. It also makes sense to buy and hold shares using a suitable and cost-effective trading platform. So a good starting place would be to compare different share-dealing accounts and Stocks and Shares ISAs on the market.
Each investor is different and what works well for one may not be the best choice for another.
Finding shares to buy
I mentioned above the idea of buying a carefully-chosen variety of proven blue-chip businesses. I think it makes sense to do what billionaire investor Warren Buffett does and stick to what you know and understand. Again, that will differ from investor to investor.
To illustrate the approach I take, I could use one share in my portfolio: Legal & General (LSE: LGEN). It has a large market of potential and actual customers, thanks to its focus on retirement-linked investments.
Legal & General has a long heritage and long brand that ought to help it long into the future to attract and retain clients. It has a proven business model and a large customer base.
My main reason to own it is for passive income. It has raised its dividend annually over the past few years and plans to keep doing so, though dividends are never guaranteed. The sale of a large US business could mean smaller profits in future and that could hurt the dividend, for example.
Building towards an income target
At the moment, the share has a dividend yield of 8.8%. So every £100 invested now will hopefully earn £8.80 in dividends annually. That is well above the FTSE 100’s average yield of 3.5%.
Still, in today’s market I think an investor could realistically aim to achieve double that (7%) from the right portfolio of blue-chip dividend shares.
In one year, £20k invested at an average 7% yield ought to provide £1,400 of passive income. That is roughly £116 each month. By reinvesting those dividends (what is known as compounding) though, an investor could build a bigger portfolio – and passive income streams.
Compounding at 7% annually for two decades, an investor could turn a £20k portfolio into one worth over £77k. At a 7% yield, that ought to generate £451 a month of income.
