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Ever wondered whether dividends from shares can really generate a meaningful second income?
They certainly can, but whether they do depends on a few factors: how much someone invests, for how long, and at what the dividend yields are. To illustrate, what sort of second income might someone be able to generate with a £20,000 sum?
Taking the long-term view
As I just mentioned , the timeframe matters. I favour a long-term approach to investing. That gives businesses time to prove themselves and, hopefully, for dividends to pile up.
There are a couple of approaches to drawing a second income. One would be to invest the £20k and start drawing down the dividends as soon as they arrive. At a yield of, say, 5%, that ought to produce a £1,000 annual second income.
But an alternative approach is what is known as compounding: initially reinvesting dividends. Then, at some point, the dividends can be switched to being used as income rather than for further compounding.
For example, after 10 years, at a 5% compound annual growth rate, the portfolio ought to be worth around £32,578. At a 5% dividend yield, that should produce some £1,628 a year in second income.
Or continuing to compound for another 10 years instead, the portfolio ought to then be worth over £53,000. At a 5% dividend yield, that could produce a second income of £2,653 a year.
Getting started
Diversification is a simple but important risk management strategy: £20k is ample to spread over multiple shares.
Dealing fees and commissions could also swallow up money, so the savvy investor should weigh their options when it comes to choosing a share-dealing account or Stocks and Shares ISA.
Big dividend payer
I mentioned a 5% target yield as an example. Actually that’s quite a bit larger than the current FTSE 100 yield of 2.9%. But I think it is still possible while sticking to quality blue-chip companies.
One income share I think investors should consider is British American Tobacco (LSE: BATS). The company has a global footprint, strong distribution network and a stable of premium brands such as Lucky Strike that give it pricing power.
Raising prices can help to mitigate declining sales volumes but only so far, if volumes decline badly enough.
British American offers a dividend yield of 5.6%. The prospective yield is actually higher, as British American aims to keep raising its dividend per share annually, as it has done for decades.
Dividends are not guaranteed though — and the decline in cigarette sales is a risk. On top of that, the company lost volume share in top markets last year. As market size shrinks, maintaining or growing share would be better for performance.
Meanwhile, the company is also growing its non-cigarette business while cigarette use declines.
From an ethical perspective, not all investors are comfortable with tobacco stocks. Personally, I think the share has ongoing substantial dividend potential.
This story originally appeared on Motley Fool
