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Ever thought of putting your feet up and letting some stock market investments do the work for you instead?
Some people do that, building up a portfolio of dividend shares and then living off the income they generate. It can sound a tempting plan – but what might it take in practice?
Setting a target
First you need to decide how much you need for your living costs. This will vary depending on an individual’s financial circumstances and needs. As an example though, I will use the industry body Pensions UK’s Retirement Living Standards.
For a “moderate” lifestyle, it estimates an annual cost for one person of £32,700. At the current FTSE 100 yield of 3.1%, that would require a portfolio worth around £1.1m.
Still, even while sticking to blue-chip shares, a higher yield could be a realistic target. At 5%, for example, hitting the annual passive income target would take a portfolio worth £640k.
Understanding the risks matters
But unlike a government bond, a share’s dividend is never guaranteed. It can be cut or cancelled at any time (the same thing can also happen with government bonds and often has done with some overseas issuers, though the UK government has never formally defaulted on its debt).
That helps explain why diversifying the portfolio and selecting shares to buy with care are both important.
But it also highlights one of the possible downsides of such a plan – even with the right amount of money invested, the income could suddenly fall or potentially even dry up altogether.
Then again, the opposite can happen. As dividends aren’t fixed, companies can increase them – and many do. That could come in handy given the impact inflation may have on the cost of living in years and decades to come.
Getting ready to invest
A practical way to buy the shares would be a good start, such as a Stocks and Shares ISA or share-dealing account.
Adding the money in one fell swoop may not be an option for many people (and anyway would exceed the annual £20k contribution allowance for an ISA).
An alternative could be putting in it over time, initially reinvesting dividends in the stock market to try and speed things up – something known as compounding.
Doing that, investing £20k a year and compounding it at 5% annually, hitting the £640k target I mentioned should take 20 years. Smaller contributions could also work, but with a correspondingly longer timeframe.
An income share to consider
One UK dividend share I think merits consideration right now is FTSE 100 tobacco firm British American Tobacco (LSE: BATS). The company offers a yield of 5.4%, above the target I mentioned above. The company also aims to keep growing its dividend per share annually, as it has already done for decades.
Tobacco companies are not for all investors, depending on their ethics. There are other risks too – declining cigarette sales volumes are already having an impact on British American’s business results. That looks set to continue, even though the company’s premium brand portfolio gives it some pricing power.
Still, the proven business model remains highly cash generative.
The cigarette market is shrinking but could still stay sizeable for decades to come. The company has also spent heavily on building its non-cigarette business.
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Christopher Ruane does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
