Earning a second income does not necessarily mean taking on a part-time job. One alternative I use is buying shares I think can pay me dividends in future.
Doing that with a £20,000 Stocks and Shares ISA contribution limit, I think I could generate around £1,600 in dividend income annually. Here’s how.
Picking great dividend shares
At the heart of my approach is spending £20,000 on a diversified portfolio of five to 10 shares I think could pay me juicy dividends for years to come, relative to what I pay for them.
How could I choose them? I would stick to large, blue-chip companies with businesses I felt I could understand well enough to assess. Then I would ask myself a few simple questions.
Does the business operate in a field I expect to keep experiencing high customer demand, whether it is selling groceries like Tesco or offering telecom services like Vodafone?
Within that area, does the company have a competitive advantage that can help build customer loyalty based on something other than price? That can be important for profit margins and dividends are basically a way of distributing profits to shareholders.
This competitive edge could be iconic brands, like those owned by Unilever, a proprietary formula such as AstraZeneca holds for some pharmaceuticals, or a unique distribution network like that of National Grid.
Next, does the company have the ability to pay profits out as dividends? Sometimes there may be other priorities. A large debt pile, for example, could need to be serviced. Indeed, that is one reason I sold my Vodafone shares this year. I was concerned that the company’s debt could lead to a dividend cut.
Looking at yields
However, even a great share has its price. If I buy at too high a cost, it could turn out to be a bad investment.
In the context of setting up a second income, the price I pay also influences how much I might earn. We talk about this in terms of dividend yield. That is the annual return I expect from a share as a percentage of what I pay for it.
Targeting £1,600 in second income per year from a £20,000 ISA requires me to have an average yield of 8%. I could do that by buying shares that yield 8% now, although I would focus on quality and value, avoiding the trap of buying a share just because it has a high yield.
But if my average yield now was lower than 8%, I might still hit my target. Dividends could rise over time, for example, although they could also fall. In addition, I could compound my dividends initially. That means reinvesting them in more shares. Doing that, at some point in future, I would hopefully hit my target annual second income of £1,600 – or more!
