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Passive income ideas come in many shapes and sizes, but I like to keep it simple.
My preferred approach to trying to earn some extra money without working for it is buying shares in blue-chip companies that pay dividends.
Three reasons I like dividend shares
That approach works well for me because it is genuinely passive. I benefit financially from the success of proven companies.
It is a passive income idea I can tailor to my own situation. In this example, I use £20K to illustrate. But the same basic principles could apply with much less or far more (though the income earned would vary accordingly).
Another thing I like about dividend shares is that the passive income can get pretty substantial. That is especially if someone is willing to adopt a long-term approach.
Turning idle money into an income machine
Investing £20K would give an investor enough to diversify across a range of companies. That helps to reduce risks if one of them turns out to disappoint.
The amount of income earned will depend on what is known as the dividend yield. Yield is basically the annual passive income from dividends expressed as a percentage of the cost of the shares.
At the moment, the average dividend yield of the FTSE 100 index of leading blue-chip shares is roughly 3.4%. But that is only an average, with some shares offering higher yield and some less (or even zero — many companies do not pay dividends). So, I think a 7% target yield could be achievable. That may involve buying a mix of higher and lower-yielding shares.
That would generate £1,400 of passive income annually. But by reinvesting that (known as compounding), someone could aim to build up a larger level of dividend earnings in future.
For example, compounding £20K at 7% for 30 years, the portfolio should grow so large that it generates an average of £888 each month in passive income.
Getting started today
Thirty years is a long time to wait, but time can be the smart investor’s friend.
As I said above, owning dividend shares is a flexible idea, so it is not necessary to wait decades while compounding before earning passive income, but a shorter timeframe would mean lower passive income streams.
I take the long view when it comes to assessing business prospects too.
For example, one share I own in my portfolio is Guinness brewer Diageo (LSE: DGE). So far it has been a weak performer. The share has lost value since I bought it.
While Diageo’s track record of raising its dividend per share annually for decades is impressive, the current yield of 3.8% is decent but not stellar.
But I continue to hold because I think fears about risks such as a decline in drinking among younger generations and lower demand for premium brands in a weakening economy have been overdone.
There are indeed risks. However, over the long term I expect alcohol demand to be high. Diageo’s portfolio of premium brands gives it pricing power. This in turn means it can generate large free cash flows to fund dividends.
Putting the plan above into action requires some way to buy or own shares, so a useful first step would be to set up a share-dealing account or Stocks and Shares ISA.
