Buying shares that pay dividends is one way to try and earn passive income.
Can it work? Can it ever! With a long-term time horizon and careful selection of shares to buy, a £20k pot could potentially produce almost £11k a year in passive income.
Snakes and ladders
How so? If someone compounds £20k at 8% annually for 25 years, the portfolio will be large enough that an 8% dividend yield would equate to passive income of £10,958 a year.
That compounding could come from both dividends and capital gains, though any capital losses would eat into it. Meanwhile, an 8% dividend yield is well above the current FTSE 100 average of 3.3%.
However, with careful selection of shares, I think an 8% compound annual growth rate is achievable.
Dividends are never guaranteed and even great companies can disappoint, so it is important to diversify across a range of different shares. £20k is ample to do that.
Finding shares to buy
When looking for shares that I hope can pay me passive income, I look at the current dividend – but much more besides.
Whether the payout is small or large, I want to understand how likely it seems to be sustained in the future.
To pay a dividend, a company needs spare cash. So I look for a proven business with a competitive advantage in an industry I expect to have resilient customer demand.
One to consider
As an example, one share I think investors should consider for its passive income potential is FTSE 100 insurer Phoenix Group (LSE: PHNX).
It is not a household name, though some of its brands like Standard Life are (so much so that Phoenix plans to rebrand itself as Standard Life).
Phoenix operates in the dull but crucial world of retirement and pension products. It has millions of customers, such as former company employees drawing down their pension plan. By buying old books of pensions as well as writing its own business, Phoenix has built a huge business.
It aims to increase its dividend per share each year. As dividends are never guaranteed at any firm, whether it is able to do that remains to be seen. It has managed to in recent years, though. The current dividend yield of 8.4% is above the target compound annual growth rate I mentioned above.
However, Phoenix’s share price has fallen 7% in five years and one risk I see is a weak property market hurting the value of some of Phoenix’s mortgage book.
From a long-term perspective though, I like the look of Phoenix.
Getting started
Dividend shares offer lots of passive income potential – but only if you own them! A useful first step is selecting a share-dealing account, Stocks and Shares ISA or share-dealing app.
