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One way to build passive income streams is to put a lump sum into buying a diversified portfolio of dividend shares.
Over time, that can prove to be a lucrative approach. Dividends are never guaranteed to last at any company though (and many do not pay them to start with), so carefully choosing the right shares to buy is important.
Here’s how dividend shares can help build income
When a company earns more cash than it needs to run its business, it may decide to distribute some (or even all) of it to shareholders in the form of dividends.
At the moment, the dividend yield for the FTSE 100 is 3.3% (coincidentally, that is the same as for the FTSE 250 and FTSE All-Share indexes at the momentmm too). That means that, for every £100 an investor put into the FTSE 100 today, they would hopefully earn £3.30 a year in dividends. Over time, that amount could go up or down based on what dividends companies decide to pay out.
Some shares pay more than that average. I think that it is realistic, in today’s market, to target a 7% dividend yield while sticking to proven blue-chip company shares.
With an investment of £20k, that would equate to an annual second income of £1,400. But a patient investor could target more – perhaps much more – by reinvesting dividends for a number of years before drawing them as passive income.
That is known as compounding. Compounding £20k at 7% annually for 20 years would see a portfolio grow to a size where a 7% dividend yield equates to an annual passive income of around £5,418.
Finding shares to buy
An important part of this passive income plan is careful selection of shares. Not only does that matter in terms of hopefully finding businesses with sustainable dividends, it also matters because falling share prices could eat into the value of the portfolio.
By contrast, shares going up in price could mean an investor ultimately benefit from capital gains as well as passive income in the form of dividends.
One share investors could consider for its passive income prospects is British American Tobacco (LSE: BATS).
At the moment, the FTSE 100 company’s high yield is 5.5%. That is sharply lower than several years ago, but that is not due to a dividend cut.
In fact, the company has grown its dividend per share annually for decades. The lower yield than before simply reflects the strong share price performance in recent years.
British American aims to keep growing its dividend per share annually. But with cigarette sales volumes in long-term decline across key markets, time will tell whether that is possible.
With its strong brands and proven cash generation potential though, I reckon British American merits consideration.
Getting going doesn’t need to be complicated
Putting such an approach into action requires an investor having a way to buy shares, so a useful first step would be setting up a share-dealing account, Stocks and Shares ISA or share-dealing app.
