Dividend stocks are among several options available to individuals interested in building a passive income. Personally, the thought of seeing money appear in my account despite doing no work is quite alluring. But how do stocks help me achieve this? And what are the risks to be aware of. Let’s explore.
Generating passive income with dividend stocks
What can often be forgotten is that when an investor buys shares, they’ve just bought a piece of a company. So, if I were to buy some stock in a business like Lloyds, it’s not incorrect for me to say I part-own Britain’s largest bank. And the same applies to any public company.
As fun as the bragging rights might be, they’re not the interesting part of the transaction. As an owner, I have a claim on the profits of the companies I invest in. How these profits are distributed is up to the leadership team. But a common method, especially among more mature businesses, is dividends.
Dividends are essentially payments issued to shareholders (the owners). The amount received is determined by the dividend amount times the number of shares owned. So, the more shares I buy, the bigger my dividend cheque will be.
The money used to pay dividends is usually taken from the spare capital that a business has and doesn’t need for ongoing operations or future projects. The amount paid is declared a couple of months ahead of the actual payment date. And dividing the dividends paid per share by the share price, I get the dividend yield. In simple terms, the bigger the yield, the more money I get.
Nothing is risk-free
As exciting as the prospect of getting ‘free’ money from dividend stocks may be, there are some issues to be aware of. Firstly, dividend payments are entirely optional for a company. That means they could disappear at any time with relatively short notice.
Don’t forget dividends are paid to shareholders from the excess capital of a business. If the company runs into financial turmoil, as many did in 2020, these payments often get cut or even outright cancelled. Even Lloyds, despite being a multi-billion pound business, suspended dividend payments when the pandemic broke out.
Something else to be wary of is a very large dividend yield. Don’t forget this figure is a function of the share price. As such, if a stock suddenly drops, the yield goes up. And when a stock falls drastically, it typically means something is very wrong, with a dividend cut possibly on the horizon. That’s why double-digit yields are often a red flag for many income investors.
Crunching the numbers
Over the last five years, the FTSE 100 has generated a dividend yield of around 3%-4%. But by being selective in the stocks I buy, targeting an annual yield of 5% without being exposed to lots of risk is achievable, in my opinion.
To generate £500 a month at a 5% yield, I would need to invest £120,000 in the stock market. That’s quite a big chunk of capital. However, if I were to build up this lump sum over time by investing £1,000 a month, it becomes far more obtainable. And thanks to compounding effects, it could theoretically only take eight years if I started from nothing.