Getting money without working for it has obvious appeal. While it may sound unlikely, passive income is actually a reality for many people. One of my favourite passive income ideas is investing in shares that can pay me dividends. Here is how I would do that in seven steps to target a monthly income of £250.
1. Decide a daily saving target
Unlike some passive income ideas, I can start investing in dividend shares even if I do not have a lot of money upfront. But I will need some funds. So, if I am starting from zero, I would set myself a daily target of how much to put aside. It does not have to be a lot: even a few pounds a day adds up over time. But I think I would do better to keep it consistent, however much it is. That way, I would be more focused on regularly saving at the same rate.
Why daily? Again, it is all about building up discipline in the habit. Over time, there will be other calls on my spare money. If I get into a firm habit of regular saving, I feel I will be more likely to stick with it.
2. Set up a share-dealing account
In the beginning, as I save some money each day, it may take some time to build up enough to make it worthwhile for me to start investing. But when I finally do, I will need some way to buy shares, such as a share-dealing account or Stocks and Shares ISA.
Getting this in place early means that whenever I am ready to use it in future, I will be able to do so.
3. Learn how the stock market works
A common mistake people make is thinking that a good business makes a rewarding investment. Sometimes it does – but not always. There can be all sorts of things about how the stock market works that are not obvious from the outside. I could learn the hard way by making expensive mistakes when I start trading (some of which will probably still happen, realistically). Or I could learn the easier way by reading up on the stock market, getting the hang of concepts like share valuation and dividend yields.
One way to do this would be to pick a few businesses I felt I was familiar with – these might be high street names like Greggs or JD Wetherspoon, for example. Then I could look at their annual accounts, which are usually available free online. Trying to connect the business I know with what the accounts say, then understanding the company’s share price, will help me learn more about how the stock market seems to work.
If the idea of reading accounts puts you off, don’t let it. Investing money in a company without understanding its finances is not investment but speculation, I feel. I think it is important for all investors to be able to read at least a basic set of financial statements.
4. Draw up a longlist
Next I would get into the nitty gritty of finding dividend shares I could use to start building passive income streams.
To do that, I would follow a few straightforward principles. First, I would stick to businesses I felt I could understand. That gives me more chance of being able to assess their long-term business prospects. Secondly, I would not look just at dividend yield. Instead, I would pay attention to whether a company seemed likely to maintain strong free cash flows in future. Those are essential to paying a dividend.
For example, does the company have some competitive advantage that could help it maintain such free cash flows? That could be a strong brand, like Games Workshop. It could be an entrenched distribution network, like National Grid. It could be patented products, like Victrex. Whatever it is, I would be looking for some business advantage I reckoned could keep free cash flowing – and dividends.
5. Build a portfolio
No matter how good one business seems, it could run into unexpected problems. That is why I always diversify my portfolio across different companies and business areas.
Using that approach, I would decide on the first few share purchases I wanted to make. I would then be ready to start buying.
6. Focus on my target
If my target is £250 per month, that comes to £3,000 each year in passive income.
If I bought shares with an average yield of 5%, I would likely need to invest £60,000 to hit my target. I could invest £60,000 upfront if I had it. But if my plan is to save each day, I need to recognise that it may take a long time to hit my monthly passive income target of £250. That depends how much I put in each day.
Saving £5 a day, for example, I would have £1,825 at the end of my first year. At a 5% average yield, that would give me monthly passive income of around £7.60. That is a welcome start – but a long way off £250. If I could afford it, I would increase my daily contribution to a much higher level. If not, I would keep paying the same amount each day and keep my eyes on the £250 – but recognise that it is a long-term target.
What I would definitely not do is invest in shares just because they had very high yields. I would always stick to shares that met my investment criteria. It does me little good to buy a very high-yielding share today only to discover next month that the company’s business is in trouble and the dividend gets cut!
7. Let the passive income roll
Next I would do little except keep paying in my daily contributions.
My approach is built for the long term, so I would not try to trade shares frequently. I would focus on finding the right sorts of shares in the first place, then holding them unless their prospects changed. After all, passive income should not involve more work than necessary!