We are all familiar with what is called passive spending – money going out the door without even the slightest effort on our part! But what about the opposite – passive income?
The theory of passive income is that people can earn money without working for it. While that may sound too good to be true, an example of such an approach I use is investing in shares that pay me dividends. Here is how I could start to do that from scratch, targeting £500 of earnings each month — without working for it.
Step one: use money to make money
I could start this plan without any savings. But when I want to buy dividend shares, I will need to have money to invest.
So my first step would be to start setting aside money on a regular basis I could use to invest. I would target a regular set amount, monthly, weekly or even daily. And that target would be one I felt was realistic, given my financial situation, which maybe different for others.
Step two: prepare to buy shares
Next, although I would not yet have enough money to start buying shares, I would get ready to do so when the time is right.
Step three: learn how shares work
The third step is the one I think might take the most time. That is learning about how shares work. A lot of people who have never invested reckon they could do so successfully. In some cases they could but, like anything in life, there is a learning curve.
For example, I would want to learn about the difference between a good business and a rewarding investment. A case in point. I think Aston Martin has a good business selling luxury cars. But I would not invest in it hoping for a passive income, because the company’s debt burden means I think it is unlikely to be paying out any time soon.
I would also want to learn about valuation. I like engineer Spirax-Sarco’s record of raising its dividend annually for 54 years. But its share price trading at 36 times earnings is too pricy for my tastes.
The more I can learn about how companies are valued and topics like dividend coverage and free cash flow, the better placed I think I will be to put my plan into action.
Step four: start buying shares
Once I had the funds and knowledge then I would hunt for shares I could buy. I would not rush. Instead, I would be happy to wait for companies I thought had good businesses to become available at an attractive price.
Not all investments work out equally well – I have owned some real stinkers! So I would reduce my risk by diversifying across a range of shares.
Step five: enjoy the passive income!
To get to my monthly target of £500 I would need a portfolio of around £120,000 worth of shares yielding an average of 5%. I could hit the target with less or more, depending on the yield. But I would never buy just for yield.
Instead, I would hunt for the sort of quality companies with great prospects I discussed above.
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C Ruane 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.