Passive income can be created in a number of ways. Yes, there’s buy to let properties or even dropshipping, but both involve a lot more time than I have. One of the main methods I use to achieve passive income is by investing in dividend shares. I find it’s an efficient use of my time and dividend payments trickle in every quarter or so.
Setting up passive income investments
To begin, I’d look at how much I want to invest and the level of passive income I could potentially achieve. For example, let’s say I have £500 that I can save and invest every month. That’s £6,000 per year.
Now, the average FTSE 100 dividend yield is around 3.5%. So the largest 100 companies listed in the UK pay a dividend income of approximately 3.5% every year. With some further research I aim to achieve a bit more than that. By carefully selecting a basket of suitable dividend shares I think I can earn around 5%-6% per year.
With my £500 per month invested in dividend shares, that’s roughly £360 of passive income every year. Now, what if I didn’t need to take the income straight away? I could reinvest that £360 and earn dividends from my dividends. And that is the beauty of compounding. Compounding is a key factor in how legendary investor Warren Buffett amassed one of the largest fortunes in the world.
If I continued the process for 10 years, I calculate that I could build a pot of £82,000. That could give me a passive income of almost £5,000 per year thereafter.
Finding the best dividend shares
To find shares that pay a dividend yield above the FTSE 100 average involves some further homework. I could sort the FTSE 100 companies from highest to lowest by dividend yield. However, that results in some particularly high yields. I tend to disregard companies paying over 9% as the dividend payments might not be sustainable. I’d look for companies that can offer sustainable income. I like reliability, so a long history of pay-outs is also on my checklist.
Three dividend shares that currently stand out to me for reliable passive income are Vodafone, Rio Tinto, and Aviva. Each offers a dividend yield of just under 7%. All three also have a long history of paying dividends.
Factors to consider
Something to bear in mind, though. Past dividend payments are unrelated to future dividends. Dividends are typically paid from earnings, so if earnings fall, then so can the level of dividends. We saw this in the March 2020 stock market crash. The uncertainty at the time caused many companies to temporarily suspend dividends.
Also, it’s important to remember that it’s not just all about dividends. Another factor to consider is the share price. I’d want the value of my investments to rise, and at the very least not fall. So it’s important to try to find companies that can sustain their business models and earnings.
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Harshil Patel 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.
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