Instead of working more hours each week, owning income shares and collecting the dividends from them could be a way for me to build my earnings.
But how might that work in practice? Below I lay out an example where I target £500 in dividend income each month.
Setting a target income
I think it can be helpful as an investor to set a target. That way, when I invest, I know what I am hoping to achieve and can design my investing strategy against that.
When setting a target, I want to make sure it is achievable. I see no point in hoping to earn £10,000 a month in income if I only have £1,000 to invest, for example. If I set a realistic, achievable target, then with fortune, over time I can increase my wealth. In that case, I may have the financial means to help me target higher amounts in future.
£500 a month of income adds up to £6,000 a year. That is a substantial amount – and I think I would need to invest quite a bit of money to try and hit it with the dividends from income shares.
Understanding dividend yields
Exactly how much I need to invest would depend on the average dividend yield of the shares I buy.
That is basically the annual dividend expressed as a percentage of the price I pay for the shares. So, for example, if I pay £100 for shares and earn £3 a year in dividends from them, we say that the yield is 3%.
With a 3% yield, hitting my target would require me to invest £200,000. If the average yield was 5%, I would need to buy £120,000 worth of income shares. I could hopefully hit my target by spending £60,000 on shares with an average yield of 10%.
Hunting for quality income shares
So, should I just buy the highest-yielding shares, whatever they are?
Absolutely not! Knowing a dividend yield helps me understand what I might earn from a share, but it tells me nothing about the underlying business. Dividends are never guaranteed, so if I invest in a business that fails to make enough profits in future, it could cut or cancel its dividend.
Instead, I always look for a company in an industry I expect to do well in future. If the company has a competitive advantage, that could help it make profits. Then I look at the share price, to see whether I think it offers me value. Only at that point would I consider its dividend yield.
So, for example, a share I own is polymer-maker Victrex. I expect demand for polymers to be resilient and Victrex has patents meaning only it can legally make certain products. The yield is 3.4%. I own other income shares with higher yields, but I think a 3.4% yield from what I see as a quality company is attractive.
But no matter how much I like Victrex — or any other income shares — even a great company can run into unexpected problems. So to try and hit my monthly target, I would invest across a diversified range of companies. And remember that first and foremost, I would be hunting for quality businesses I thought had a bright future.