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One way to try and build a second income is to build a portfolio of shares that pay dividends (or, more accurately, that one hopes will pay dividends in future).
That can be lucrative – but there are also some possible pitfalls. Here are four things I think a savvy second-income hunter ought to consider when using such an approach.
Do: know what you’ve investing in
It may sound obvious, but it is important to know what you are buying. Otherwise it is not investment, but merely speculation.
Buying shares because they have a juicy dividend yield without understanding the business, its balance sheet, and likely future cash flows (as much as they can be estimated) is pure speculation. It can be a costly mistake.
Do: consider where future dividends will come from
Understanding a business is important for an investor for a number of reasons.
One is that dividends are never guaranteed, even when a company has paid them steadily for years or even decades.
To keep paying dividends, a company needs spare cash. It also needs to decide to spend that cash on dividends, rather than other possible uses such as business expansion or paying down debt.
That is why free cash flows are so important when it comes to dividends.
Don’t: put all your eggs (or even most of them) in one basket
One common mistake investors make is having too much of their portfolio in one share.
The problem is that even the best-run company can run into difficulties. That might mean it has to reduce or cancel its dividends.
To make things worse, when a company cuts its dividend, the share price often also falls. So it can be a double disappointment. If that share is too large a part of one’s portfolio, that disappointment can mean an immediate slump in second income.
I understand why people make this mistake. Take British American Tobacco (LSE: BATS) as an example.
Not only has it maintained its dividend per share each year this century, it has raised it. It has strong brands that give it pricing power.
The FTSE 100 firm is hugely cash generative, but with cigarette sales in decline it has limited uses for spare cash (though it does have a sizeable debt pile to service).
All of that means I think investors should consider it for its future dividend potential.
However, those declining cigarette sales are a risk to sales and profits. Non-cigarette sales are growing but for now lack the profitability of cigarettes.
So I think investors should consider the share — but only as part of a diversified portfolio.
Don’t: burn income needlessly
Some investors earn a good second income owning shares, but then squander some of it unnecessarily due to dealing fees, commissions, account charges, and so on.
That is why I think it makes sense to review the different options when it comes to choosing the best share-dealing account, Stocks and Shares ISA, or dealing app.
This story originally appeared on Motley Fool
