Generating a passive income is a financial goal shared by many. After all, who doesn’t love the idea of money magically appearing in a bank account for doing no work? There are plenty of ways to go about building one. But, in my experience, the easiest and most sustainable is investing in dividend shares.
Let’s go through three steps on how I’d get started.
1. Preparing to invest
The old proverb, “it takes money to make money”, is entirely accurate. And, for many, the initial lack of funds poses a barrier to entry into the stock market. Yet, despite popular belief, this barrier isn’t as high as many people think.
In recent years, the costs associated with investing have fallen drastically. And with commission-free trading platforms, along with the invention of fractional shares, investors can get started with as little as £20.
Of course, £20 will not be enough to build a substantial passive income by itself. But if I can spare that amount each week, it quickly adds up. And within a month or two, I’ll have enough capital to start making meaningful investments into dividend shares.
Needless to say, that’s far easier than taking out a bunch of mortgages to build a rental real estate portfolio.
2. Finding the right dividend stocks
Buying and selling shares today is easy. But identifying which ones will generate long-term gains is where the challenge lies. A common mistake new investors make is going after the stocks with the highest dividend yields. After all, high yields mean more passive income, right?
Not quite. A company’s dividend yield is influenced by its share price as well as the actual payout. And all too often, it’s the former that causes higher yields. If shares of a business have suffered a sharp decline, dividend yields go up. And that’s where traps emerge.
Stock prices only tend to suffer large declines when something is wrong. And if the underlying company is in trouble, it could mean a dividend cut is on the way.
For example, back in 2020 after Carnival shares collapsed, the dividend yield stood over 20%! But, of course, anyone who bought shares looking to reap the rewards was sorely disappointed. With its business model decimated by Covid-19, its debt quickly piled up, and dividends disappeared.
That’s why high yields can often be a red flag. For reference, the average among UK shares is around 3.7%. And, in my experience, anything above 6% looks dubious. But there are exceptions.
That’s why it’s critical to investigate each stock, understand the business, and determine whether dividends can be sustained for the long run. If the answer is yes, then it becomes a viable candidate for my passive income portfolio.
3. Start earning some passive income
With my stocks selected, the last step is to buy shares and hopefully watch the money come in. It will take some time before I start earning £300 a month, especially if I start from scratch. And I know that I could lose as well as gain. But with consistent reinvestment, I could build up to my passive income goal over several years.
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Zaven Boyrazian has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.