The idea of earning some extra money without working for it has appeal. That is one of the attractions for me of buying UK shares. If they pay dividends, I can put money into them today and hopefully set up second income sources for years to come.
I do not even need to start with a lot of money. Here is how I would go about putting £100 to work each month with the long-term goal of generating £5,000 in passive income annually.
How dividend shares work
The theory of trying to build a second income by investing in dividend shares is pretty straightforward.
When a company makes a profit, it can do different things with it. For example, it might fund expansion into a new market or developing new technology. But it could also distribute the profit among shareholders. That is basically what dividends are.
Dividends are never guaranteed, even when a company is highly profitable. Google parent Alphabet is an example — it has never paid a dividend despite mammoth earnings. So if I wanted to build a second income, I would look for shares in companies I hoped would be likely to pay dividends in future. So I would look for firms I felt had an enduring competitive advantage in a market with robust customer demand.
Saving to invest
By putting aside a certain amount on a regular basis, I can build up funds to invest.
For example, imagine I put £100 each month into a share-dealing account. That would add up to £1,200 a year that I could invest in dividend shares.
The amount I might earn would depend on what is known as the dividend yield of the shares I bought. If a share costs a pound and pays out 6p per year in dividends, for example, we say that it has a yield of 6%. A number of UK shares in my portfolio currently have a yield even higher than that.
So if I invested £1,200 at a dividend yield of 6%, I would hopefully earn £72 per year. That would certainly be welcome – but it is a long way off my £5,000 target. I could try and build up to that over time, though, by continuing to put aside my monthly £100 and also reinvesting the dividends. That is known as compounding.
Doing that, after 28 years I ought to own shares worth around £84,500 and generating a bit over £5,000 in dividends per year. That example presumes constant share prices and dividend yields. But it shows how regularly saving to invest in dividend shares could help me build a meaningful second income over the long term.
Finding UK shares to buy
I could start today, putting aside money regularly and buying UK shares. If I was a beginner, I would take time to learn how the stock market works, before hunting for shares that meet my criteria.
Then, hopefully, those shares could help me grow my income streams year on year.