Passive income is money that one generates without working for it. One of my favourite passive income ideas in investing in shares that pay dividends. Here’s how I would look to make £500 a month by doing that.
What are dividend shares?
Some shares pay out money to investors. This money is basically a share of the company’s surplus cash. There are pros and cons to this approach. As an investor, it can be pleasing to see a regular income stream from a share. On the other hand, if a company has a strong business, it might be able to generate better returns reinvesting profits than divvying them up among shareholders. That’s why companies like Google owner Alphabet don’t pay dividends.
I mix my portfolio between what are known as growth and income shares. For passive income, I focus on dividend-paying shares. Dividends are never guaranteed, so I diversify across multiple companies. That helps lower my risk if one company starts to underperform.
How yield affects passive income
‘Yield’ is the percentage income one gets from an investment. If I invest £1,000 in a bank account and the interest rate is 1%, I would expect to earn £10 interest in a year. The annual yield is the same as the interest rate: 1%. For a share, the calculation is similar, but can be a bit harder to figure out. Dividend changes and share price swings can affect it. So, for example, the share price of Shell is around £14.77. Last year it paid a dividend per share of 65c, which is around 47p. A 47p return on a share price of £14.77 equates to a yield of about 3.2%.
Why yield matters
But what a company paid last year gives no assurance of what it will do in future. Dividends are never guaranteed. In this example, last month Shell announced it would increase its second-quarter dividend by 50%. If it did that for all dividends in future, that suggests the “forward yield” at today’s share price would be 4.8%. So, putting £1,000 into Shell shares today could possibly earn me £48 in passive income in the coming year.
Yield matters because, if I wanted to generate £500 a month in passive income, a yield of 4.8% would allow me to do so by investing almost a fifth of what I would need if the yield was only 1%. But sometimes a high yield indicates concern about whether a company can maintain its dividend. Plus, my capital would be at risk in shares in a way it typically wouldn’t in a bank account. So I’d want to choose the dividend shares for my portfolio carefully, looking at each company’s future business prospects not just its historical yield.
Choosing dividend shares for passive income
The rewards aren’t guaranteed, of course, but if I can build a portfolio of shares yielding an average 5%, £500 of passive income a month would require £120,000 to invest. If I didn’t have that, I could start with whatever money I had available and build up the nest egg over time.
Then, I’d start picking specific dividend shares for my portfolio. Looking for shares with the sort of yield I want, I’d focus on finding high-quality companies with a proven track record and strong future business prospects.