Is it realistic to try and set up a second income without taking on an additional job? I think it is and I try to do just that by investing in dividend shares.
I like that approach because it can help me profit from the success of large companies such as J Sainsbury and HSBC that have tens of thousands of full-time employees working hard across the year. Here is how I would put such an approach into action with a target of earning £10,000 in dividend income annually.
Future dividend payers
As dividend shares are core to my plan, I would need to choose which ones to buy. As a long-term investor I would be planning to hold these shares for years, not jump in and out of them regularly. So I would want to make sure I felt confident about the quality of the shares I was buying.
Dividends are basically how a company distributes spare cash it generates that is surplus to requirements.
So I would want to find businesses that I expect to throw off a lot of spare cash in future. Often such firms have a large potential customer base and something that can offer them a competitive advantage, whether it is patents like AstraZeneca has or a proprietary distribution network like National Grid‘s.
But remember I am looking for cash that could be surplus to requirements. That rules out companies like Berkshire Hathaway. It generates a lot of free cash flow. But its boss Warren Buffett likes to use that money to make acquisitions now or save it for future use. So Berkshire, like a lot of companies, does not pay dividends even though it generates substantial amounts of cash.
Balancing my portfolio
What Buffett does do, though, is diversify his risks by investing in a range of companies.
That way, if one of them disappoints him – like an investment in Tesco did in 2014 – the impact on his overall investment returns will be limited.
I think that makes sense for me when choosing dividend shares for my own portfolio.
Hitting my target
But how will I know if £10,000 of passive income annually is within reach for me when using such an approach?
My expected dividend income reflects how much I invest and what is known as the average dividend yield of the shares in my portfolio. So if I am earning a 5% yield, for example, earning £10,000 each year would require me to invest £200,000 in total. A 10% yield, by contrast, would require the smaller amount of £100,000 to be invested.
I would not simply chase the highest yield though. Sometimes an unusually high yield can be a red flag that the City expects a company to reduce its dividend. Instead, I would focus on finding great companies at attractive prices in the way I described above. That is also the approach Buffett uses, incidentally.
Even if I had a far more modest amount to invest, I could still start using the above approach. I would simply start on a smaller scale and build up to the £10,000 target over the course of several years. Reinvesting the income from my dividend shares as I go – something known as compounding – could help me get there sooner.
The post How I’d target a £10,000 annual second income from dividend shares appeared first on The Motley Fool UK.
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings and Sainsbury (J). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.