There are all sorts of ideas out there about how to earn money without working for it. I tend to keep things fairly straightforward when it comes to trying to set up passive income streams. I like to invest in shares that pay out dividends. That way, I can benefit from the commercial success of leading companies without needing to work for the money myself.
Here is how I would seek to use £250 a month to start building up my passive income.
A standing start
One of the things I like about owning dividend shares as a source of passive income is that I can start with nothing. It is not like buying a rental property, where I may need a large deposit. Instead I can simply put aside some spare cash each month and use it to invest in shares.
The actual amount does not matter in the sense that I could grow an investment pot with any size of monthly savings. But obviously the more I save, the faster my funds will grow. I think it is worth trying to put aside enough each month so that I could feel I was making real progress within a few months. That could help encourage me to keep going when other spending priorities arise.
If I targeted a monthly sum of £250 that would add up to £3,000 a year. I could invest that in shares with an average dividend yield of around 5% and hope to earn £150 a year in passive income from my first year’s savings. I think that is enough to motivate me to keep going.
To do this, I would open a share-dealing account or Stocks and Shares ISA. As I saved money in it, I would take time to research dividend shares I could buy with the growing funds.
Dividend shares as passive income ideas
So, what exactly are ‘dividend shares’?
Dividends are basically sums of cash a company pays out to its shareholders. One can think of it as a form of profit sharing. But there is no obligation on a company to pay dividends. Some companies that have paid dividends for years may suddenly cut them or cancel them altogether, if the business environment changes or the company reassesses its spending priorities.
For example, Legal & General is a popular dividend stock. In 2007, it paid out 5.97p per share in dividends. But then the financial crisis hit and it reduced its dividends. They did not hit their old level again until 2011. Then they increased every year until 2019. The following year, amidst the pandemic, the company kept the dividend steady. Last year it began to raise it again.
Other companies scrap their dividends altogether. For example, Tesco paid a dividend in December 2014. It became engulfed in an accounting scandal and did not pay another dividend until November 2017, almost three years later. When it brought the dividend back, it was at a much lower level than it had been before it was cancelled. Even the recently announced 19% increase in Tesco’s annual dividend still leaves it 26% below where it was in 2014. Other companies scrap their dividends and never bring them back at all.
This teaches me two important lessons about using dividend shares as passive income ideas. One is that I should not focus on a company’s dividend track record as a guide to what might happen in future. Instead, I look at a company’s business model and try to see whether it has a competitive advantage that could help it make big profits in future to fund a dividend.
Secondly, no matter how attractive one company may look to me, I always invest my money across a variety of dividend shares. Both Legal & General and Tesco are well-regarded blue-chip companies with a proven ability to make sizeable profits. If even they have cut or cancelled their dividends, then any company can.
Choosing dividend shares to buy
As well as those principles, when looking for dividend shares I could buy with my monthly £250, I would follow one more rule. Investor Warren Buffett emphasises the importance of investors staying inside their “circle of competence”.
That is because assessing potential share purchases can already be very difficult. If I do it in an industry I do not understand, I have moved from investment to speculation. That does not strike me as a sensible way to try to set up my passive income streams.
So I would stick to companies and businesses where I felt I had at least some understanding of the business model and competitive landscape. This could be from personal experience – for example, if I shop at Tesco I may have my own ideas about how the business seems to be doing. But I would also look at a company’s annual report and accounts, which are usually available free online. That is because a successful business does not always make a successful investment.
For example, carmaker Aston Martin has seen sales boom. But because it loaded its balance sheet up with debt, interest payments mean it cannot convert strong sales into high profits at the moment. I am not just looking for a good underlying business, but also a good investment.
Making a move to earn passive income
That is basically that. My passive income plan consists of regular saving, research into shares I feel I understand and then buying a diversified portfolio of dividend shares I think are trading at attractive prices.
I would keep an eye on my shares but would try not to become a frequent trader. After all, my income here is supposed to be passive! If I use my monthly £250 to buy a range of quality companies at a good price, then I see no reason to sell them frequently.
Occasionally, something may happen that changes the investment case for a share I own. But otherwise, I would be content to invest the money, sit back and hopefully watch my passive income streams grow over time.