Image source: Getty Images
One common way to earn a second income is to buy a diversified portfolio of high-quality shares in the hope that they will generate dividends over the long term.
As with any passive income plan, this one has some pros and cons.
On the plus side, it is genuinely passive.
On the other side, dividends are never guaranteed to last (hence the diversification I mentioned above) and that it takes money to buy shares.
How much money? That will depend on one’s goals. In fact, another thing I like about using dividend shares to generate a second income is precisely that ability to tailor the approach to someone’s individual financial circumstances.
Figuring out the income
That said, there are a few variables that help explain how much income someone can hopefully expect.
Briefly put, the two key things are the amount invested and the dividend yield. Dividend yield is the amount of income expected each year as a percentage of the cost of the shares.
For example, at a 10% yield (unusually high in the UK market right now), a £15,000 annual second income would require a £150,000 investment. The same maths apply to a higher goal: a £150,000 second income would require a £1.5m investment.
If the yield is lower, the amount needed is higher. Take 5% as an example: still well above the current average FTSE 100 but within reach while sticking to blue-chip shares in today’s market, I reckon.
At that yield, a £15k or £150k second income would require an investment of £300k or £3m, respectively.
That may make it sound as if the thing to do is target high-yield shares. But remember – dividends are never guaranteed. A high yield can be a red flag, indicating that the City expects a dividend cut (though that can happen even to shares with low yields).
Incidentally, the savvy investor ought also to consider a cost-effective share-dealing account, Stocks and Shares ISA, or trading app.
Using compounding to your advantage
Either way, the sums involved above are substantial.
Fortunately, the target could still be in sight for an investor with less (or even no) money to invest upfront, and a long-term timeframe.
By compounding (reinvesting) dividends and share price growth gains, an investor can build their portfolio value significantly over time.
Let me illustrate. If an investor puts in £500 each month and compounds their portfolio value at 8% annually, after 16 years it will be large enough that an 8% yield would generate a £15,000 annual second income.
Or, after compounding for 42 years, an 8% yield would mean £150,000 of annual second income!
Getting started
One share I think investors should consider both for share price growth and dividend potential is insurer Aviva (LSE: AV).
The share price is up 123% over five years. Since a dividend cut five years ago, the FTSE firm has steadily grown its payout per share and now yields 5.7%.
Aviva is the insurer with the most customers in the UK. Its recent acquisition of Direct Line adds more customers and should boost revenues.
But I do see a risk the acquisition might distract management from the core business. However, with strong brands, long underwriting expertise, and resilient demand, I think Aviva is worth considering.
