Investing to earn a second income is arguably one of the most popular financial objectives shared by investors. After all, who doesn’t love the idea of making money without having to work for it. And when leveraging the power of a Stocks and Shares ISA, even taxes are eliminated from the equation.
However, investing a £20k ISA can be a bit daunting. And if executed poorly, it can actually end up doing more harm than good. After all, investing in stocks isn’t risk-free. So let’s explore what to be on the lookout for and how to start earning an extra £1,200 right now.
The risks surrounding dividends
When a company reaches maturity, growth tends to eventually slow. There are only so many projects a company can invest in, and not all can deliver blockbuster returns. For example, a new product that generates an extra £5m in sales each year could be tremendous news for a small-cap. But for a multi-billion pound industry titan, it’s fairly meaningless.
As such, large businesses often choose to return the money they can’t find a good use for back to shareholders through dividends. And capitalising on these payout policies is how investors can earn a second income in the stock market.
However, this is where risk enters the picture. Even if a company pays a high dividend right now, there’s no guarantee it will continue to do so. Why? Because dividends are ultimately funded by money that a business doesn’t need. And when times are tough, these funds can quickly end up in short supply.
That’s why so many income stocks had to hit pause on dividends during the pandemic. And a portfolio of companies with weak balance sheets and lacklustre outlooks isn’t likely to generate a sustainable passive income.
Earning £1,200
On average, the FTSE 100 has typically offered a dividend yield of around 4%. Right now, the payout is closer to 3.6%, due to the rally we’ve enjoyed since the start of 2024. However, even with this recent boost, there are still plenty of companies offering considerably more.
There are currently 19 groups supplying a yield of at least 5%. And expanding the sandbox to include the FTSE 250 increases this to 70 companies. By snapping up the right blend, building an income portfolio that yields 6% would instantly generate a £ 1,200 second income when starting with a £20k ISA.
Sadly, not all of these enterprises are going to be sound investments. Take Diversified Energy Company (LSE:DEC) as an example. Until recently, the oil & gas producer offered one of the highest yields on the London Stock Exchange, at 16.3%. Yet, investors who were lured in by the promise of gargantuan income are likely kicking themselves today as the firm has since announced a dividend cut.
With the largest portfolio of oil & gas wells in the US, Diversified’s a major player within the energy sector. But, environmental questions arising about how it’s able to properly manage all 90,000 wells, paired with falling gas prices, has started creating cracks in the balance sheet.
All of this is to say that when exploring high-yield income stocks, investors need to pay careful attention to the underlying business. Not just from a financial perspective, but an operational one as well.
This post was originally published on Motley Fool
