Passive income is a topic that is looked into by more people by day. More and more people are looking into ways to make money while they sleep. There aren’t many ways to make money that I would truly call passive. The only one that comes to mind – dividend investing.
Below I will give a short summary of key positives and negatives of this strategy. This won’t work for everyone certainly. Those who see the potential in this strategy – I will be sharing more details on what exactly to look at when building your dividend portfolio. This will be in a separate post at a later date.
what is dividend investing strategy
Dividend investing strategy is when an investor is buying into shares/ETFs with the key priority being dividends that he can receive.
When an investor buys dividend paying assets – he firstly needs to invest his own money into assets that will pay him an annual dividend. The annual dividend can be divided into multiple payments. Many companies often pay quarterly or biannually.
The return that you make on these assets is called a yield. Let’s imagine you put £1,000 into an asset that pays a 10% annual yield. This would result in you receiving £100 each year you hold this asset. If the dividend is payed quarterly – this would be equivalent to 4 dividends of £25 each.
One thing worth keeping in mind when it comes to shares of the companies – dividends are never guaranteed. A company can cancel these at any point.
If a company cancels its dividend – this can be a really painful outcome for an investors. Not only one is loosing their annual income – the price of the asset is very likely to be hit by these news as well.
An example of this can be – Direct Line Insurance in the UK in early January of 2023. A company that was paying a dividend of over 8% has canceled its dividend due to a high number of claims during extremely cold weather in winter in the UK.
Firstly, investors can no longer expect to receive their dividend. Secondly, as many started selling these shares at the same time – the share price dropped by nearly 25%. This is a massive loss for investor to swallow from both value and dividend income point of view. You can read an article on this with more details here.
what makes dividend investing a truly passive income strategy
The reason this strategy is truly passive income – you invest once and there is nothing else you need to do. Well… you have to think of how to spend your dividend income.
Once your money is invested – there is nothing else you would be expected to do. Few minor steps on the journey – keep adding to the portfolio as well as make sure you reinvest the dividends.
For those with more complex portfolios that consist of hand picked shares of companies – you might be required occasionally to rebalance your portfolio to make sure you have the right levels of exposure to the right types of shares.
how to maximise the odds and yields from this strategy
The beauty of this strategy however is when you are investing into an index fund or have a large portfolio of shares where a loss of income from one asset can be easily covered by the rest of the shares in your account.
Below I will review how investing into the top 100 biggest UK companies can be an amazing strategy for those hunting for dividends. And no – for this to work, you don’t have to buy and hold 100 individual companies in your account. You can simply buy into FTSE 100.
FTSE 100 is an index fund of 100 biggest UK companies. Many of these pay dividends. As a holder of a wide market index fund – you will also be entitled to a dividend payment that will be the average of all the companies within the FTSE 100. This is a weighted average to keep this mind.
The key benefit of holding a broad market index fund – while one asset can under perform, the rest can pull the value of total index up. This is exactly what happened in the week when Direct Line declined 25%. Total FTSE 100 gained nearly 2% in its value.
Not only you get the protection of rapid losses due to one particular asset underperforming – you also get paid a dividend. Currently FTSE 100 pays a dividend of roughly 3.7% per year. This means – for every £1,000 invested – you will be paid £37 annually.
While this might not seem high – there is an additional benefit to this. If we look at the historic performance of FTSE 100 – the value of the index has grown an average of 5.2% over the last 39 years.
This would result in investor banking himself nearly 9% annual growth if both are combined.
yields don’t always look great
As you have probably already guessed – one of the key issues with this strategy is the amount of dividends that are paid out. If dividend is the only source of income you want to rely on – dividend yields of 3.7% aren’t the best.
We can take an example of a potential investor looking to boost his or her monthly income by £1,000 received purely through dividend income. This is a total of £12,000 per annum.
If this investor was to pick FTSE 100 as his primarily investment vehicle with an annual dividend yield of 3.7% – the total investment pot required to receive £12,000 annually in dividend payments would be equal to £325,000.
This is a large sum of money one has to invest in order to be getting £1,000 back every single month for the rest of his life.
The biggest advantage and benefit to this – this income would truly be passive and wouldn’t require you to do anything.
If this sounds broadly like your goal – I would suggest investing through an ISA account in order to avoid paying taxes on the dividends you will be receiving annually.
the results will take time
One question you might have – is the above amount of passive income even a reality if I don’t have a large lump sum to put into the market in one go.
The answer to the above is most certainly YES. Let me explain below how you could achieve this by investing only £500 per month.
One of the biggest point to remember here – you aren’t only receiving dividends here but your investment is also growing over time. As I have mentioned above – the combined rate of growth if the dividends you receive are reinvested back into the market stands at 9%.
This means that a person who starts investing only £500 per month into FTSE 100 and reinvest all the dividends he receives would have a total account value of £334,000 by the age of 45.
The total amount of contributions the person would make over this period of time would be equal to £120,000. The remaining £214,000 would be pure value growth and dividend reinvestment. This is the magic of the compounding that happens over time.
summary
For those looking for true passive income source – dividend investing is a great strategy. You can enjoy your time anywhere in the world and spend it with people you wish while the company you invest into continues to generate money and pay you dividends.
The main issue with this strategy is the time that it takes for your investments to start delivering sizeable results. Once it starts happening though – this machine becomes unstoppable.
If dividends sounds like something you could be interested in – I would encourage investing in a broad market index rather than a number of shares that pay dividend. If one or couple of these stop paying the dividend – you will lose both the dividend income and a large portion of the value of your asset at the same time.