Dividends can be a good source of passive income. Here is my plan to invest £10,000 to set up a stream of dividend income.
Quality over historic yield
One common mistake new investors make – and a lot of older ones, too – is choosing dividend shares based purely on yield.
Ranking dividend shares by yield may sound reasonable – but I think it can be misleading. After all, when investing, what matters is future yield. Just because a company paid dividends last year, it doesn’t mean it will pay them out again. Business performance or prospects may change, for example.
So I try to avoid high yielding shares whose prospects concern me, something known as ‘value traps’. Instead, I focus on companies with attractive business models I expect to have a strong yield in future.
Diversification of dividend income
Even good companies can stumble. So I reduce my risk through diversification – basically not having all my eggs in one basket. With £10,000, I’d aim to buy five different companies. I’d also focus on different business sectors, to limit my exposure to a downturn in any one sector.
3 shares I’d pick for dividend income now
I’d start with a pick in financial services. A lot of companies in that sector offer high yields, including M&G, Direct Line,and Legal & General.
Legal & General with its 6.6% yield and progressive dividend policy attracts me. It has a strong position in insurance but also other forms of financial services. £2,000 would generate a prospective £132 of dividend income. One risk is price competition from new entrants to investment management, which could squeeze profit margins.
Utilities are a popular choice for dividend income. I would consider National Grid for my portfolio. The electricity network operator has a strong position in the UK. But it also derives income elsewhere: soon around 40% of its estate will be in the US. Yielding 5.3%, £2,000 should get me £106 of dividend income in a year. Foreign exposure diversifies National Grid but it does add risks, for example the challenges of managing assets in foreign countries with their own regulatory and pricing regimes.
Another sector I would like exposure to is consumer goods, as I think it is here to stay. Household products giant Unilever owns brands such as Marmite and Cif. It yields 3.5%, so a £2,000 stake should earn me £70 a year in dividends. One attraction is that it pays quarterly, which could help me spread my passive income streams over the year. One risk is that its food division continues to underperform due to restaurant lockdowns in many markets.
Two dividend income growers
All three of my choices so far have a recent record of growing dividends. But I’d also include two names I expect to grow at a higher rate than most shares.
Scientific instrument manufacturer Judges Scientific only yields 1.0%. But with double-digit dividend growth the norm at Judges, I’d consider it an attractive pick for dividend income. A risk is delayed spending by labs and universities whose research facilities remain closed by the pandemic.
Finally, gas, technology, and healthcare conglomerate DCC yields 2.7%. DCC grew its dividend yet again last year, this time by 10%. I like its strong management and proven business strategy. But a risk is its heavy exposure to gas sales, which could decline due to shifting environmental rules.