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Passive income plans come in all shapes and sizes. One I use is putting money regularly into the stock market and building a portfolio of dividend-paying shares.
Here is how anyone could use such a plan, starting today, to target a £700 monthly passive income from dividends.
Step 1: set up a share-dealing account
When the time comes to buy shares, a dealing account of some type will be necessary. So the first step would be looking at the different share-dealing accounts and Stocks and Shares ISAs that are available on the market and choosing a suitable one.
Step 2: setting up a regular contribution
£700 a month amounts to £8,400 a year. In a portfolio with a dividend yield of 7% (meaning it pays £7 in dividends annually for each £100 invested), that would require investing £120k.
In this example I presume someone starts with nothing and makes regular monthly contributions. I illustrate with £400, but each investor could adjust the amount to what suited them personally (though that may mean they hit the target sooner, or later).
Step 3: learning about the stock market
Is 7% a typical yield? No. It is close to double the current FTSE 100 average.
But I own some FTSE 100 shares like Legal & General (LSE: LGEN) that offer such a yield, or higher. Legal & General yields 8.5% and has announced plans to raise its dividend per share annually over the next few years.
Dividends are never guaranteed though. Legal & General cut its payout during the 2008 financial crisis. Plus, even a high-yield share can fall in price over time, potentially making for a loss-making investment.
So before starting, an investor ought to learn the basics of how to be a good investor and get to grips with concepts such as valuing shares.
Step 4: starting to buy shares
Another such principle is spreading risk by diversifying the portfolio across different shares. That is good practice from day one.
Like Warren Buffett, my approach to finding shares to buy is sticking to what I understand and looking for great businesses selling at attractive share prices. If nothing looks attractive today, there is never a rush to buy.
With passive income in mind, it is important not just to focus on yield. It also matters whether the dividend looks sustainable. Legal & General has a lot of competitors. Earnings over the past several years have been weaker than before and the planned sale of a US business could reduce them further.
But it does have strengths, such as a proven business model, large customer base a well-known brand.
Step 5: reinvesting dividends
Rather than immediately earning passive income, an investor could initially reinvest dividends to build more capital. This is known as compounding.
Step 6: getting the income
Compounding £400 a month at 7% annually, the portfolio should be worth over £124k after 15 years. At a 7% yield, that will throw off more than £700 in monthly passive income on average.
Step 7: staying the course
Starting today is easy. But to achieve the target, an investor will need to stick with the plan over time. That also involves keeping an eye on the portfolio in case the investment case for any of the shares changes along the way.
