The appeal of passive income means that people come up with all sorts of wacky ideas to try and generate it. I prefer a simple, conventional one: investing in dividend shares. By buying shares in some large, successful companies, I hope to share in their good fortune when they pay dividends.
That can work on a small or large scale. Here is how I would use this approach to target £10,000 a year in passive income, for example.
Setting a target
£10,000 a year is a sizeable chunk of passive income. So it will take quite a bit of capital to generate. If I can invest in shares with a 5% yield – that means the dividend amounts to 5% of the current purchase price – I would need to invest £200,000. That is a lot of money, although it would hopefully set me up with an annual £10,000 passive income stream.
An alternative would be to start with a smaller sum and contribute regularly. That would take me more time to hit my annual income target of £10,000. But it would allow me to work up to it gradually with whatever money I could afford.
Finding the right dividend shares for me
One temptation I would avoid is investing in higher-yielding dividend shares purely so I could aim for the same target with less capital.
Higher yields on shares often indicate higher risks. For example, at the moment mining firms Rio Tinto, Evraz, and Ferrexpo all have yields of 8% or more. In fact, after a plunge in its share price today, Evraz yields an incredible 23%! But clearly there are risks in mining, with some commodity prices near record highs. Mining is a cyclical market, so in future, prices are likely to fall again and so are dividends.
But if I do not just hunt for high yields, how do I select shares for my portfolio? Basically a dividend is a way for a company to distribute free cash flows its business has generated to shareholders. So, I look for companies with sustainable competitive advantages I think it can use to generate substantial cash flows to support future dividends. If shares offer high yields that could be good for my passive income streams – but I do not look just for high yields.
Investing for passive income
Once I have found such shares, I would buy them for my portfolio. To reduce my risk, I would diversify across different companies and business areas. For example, I like both Imperial Brands and British American Tobacco as passive income ideas for my portfolio. But both are tobacco companies, so face similar risks such as declining revenues as people stop smoking.
If I was investing £200,000 across 20 shares I might find owning two tobacco shares to be within my risk tolerance. But if I was only buying shares in five or six different companies, for example, I would not want to concentrate my risk that much.
Having identified the diversified set of shares I want, I would buy them then sit back and wait hoping for my passive income to start piling up. It really is that simple!