Achieving a passive income of £30,000 a year from dividend shares is an ambitious goal. And that’s particularly true if I start investing from scratch without bunging in a lump sum.
For example, if I assume an annual return from dividends of around 4%, I’d need to invest £750,000. But that’s not my plan at all. Instead of using wealth to create a passive income, I want to use dividend shares to create wealth!
How I’d aim to compound the returns from dividend shares
The idea is to use the principles of compounding to turn regular investment sums into a pot of money as large as the £750,000 required. Can it be done? I believe it can. And in a reasonable timescale as well.
A quick scoot over to a compound interest calculator website helps to illustrate the point. If I invest £800 a month for 35 years and earn 4% a year it will compound to around £770,000, slightly exceeding the target.
Another thing the modelling shows me is that I’d have invested a total of £345,000 with those 35 years of monthly payments. But I’d have earned returns of almost £425,000 — such is the power of the compounding process when it clicks. However, I’d need to adjust my monthly investments for inflation to preserve the spending power of my eventual passive income.
But the process of compounding responds to a couple of key variables. The first is time. The absolute value of monthly returns really accelerates in the later years of a programme of compounding. So the longer I keep it up, the better.
The second variable is the yearly rate of return. If I can earn a return each year higher than 4% it will make a big difference to the size of the eventual pot of investment money. Or I could achieve my goal of £750,000 over a shorter timescale because of compounding higher annual returns.
Of course, in practice, compounding my way to £750,000 with dividend shares may not be as straightforward as the illustration suggests. Shares can go down as well as up and companies can stop paying or reduce their dividends. However, the illustration ignores the potential for capital growth from rising share prices, which could boost the investment pot over the 35-year period.
Not every dividend stock would be suitable
I’d look for shares backed by steady businesses with consistent cash flows capable of sustaining a dividend policy. So, speculative situations would be out the window. And I’d also be wary of big dividends found among companies operating in cyclical sectors.
For example, I wouldn’t try to rely on dividends from companies such as Lloyds Banking Group, miner BHP, or International Consolidated Airlines. Over a 35-year programme of investment, those types of firms will likely suffer from several ups and downs in the wider economy and their dividends could be ‘here today and gone tomorrow’.
However, other businesses in more stable sectors strike me as being suitable for my dividend reinvestment strategy. For example, I’d look at stocks such as British American Tobacco, Britvic, GlaxoSmithKline, PZ Cussons and Unilever. I’d also consider making a FTSE 100 tracker fund part of my investment plan. Even then, nothing is certain or guaranteed.