One way to generate a second income is by earning dividends from shares. If I was able to put £20,000 into a Stocks and Shares ISA today to try and earn £1,700 annually in dividends, here is how I would go about it.
Investment principles
In allocating the money, I would stick to some basic investment principles.
One is reducing my risk by diversifying across different shares. With £20,000, I could split the money evenly across five to 10 different companies.
Another is focusing on quality companies that are proven dividend payers.
Ideally I would like to invest the Stocks and Shares ISA and then largely forget about it, except for receiving a steady stream of dividends. Past performance is not a guide to what will happen in future. But hopefully, a strong focus on quality businesses could let me sleep peacefully. I would only check on my ISA a few times each year to see whether anything had changed to affect the dividend outlook of the shares I owned.
Finding big dividend payers
To earn £1,700 in annual dividends from a £20,000 ISA, I would need to achieve an average dividend yield of 8.5%. As that is an average, some shares could have a lower yield, as long as overall I still hit my target.
What sort of blue-chip shares might pay such a yield?
Looking at FTSE 100 shares that currently yield 8.5% or above can give some clues. Such firms include M&G, Legal & General and British American Tobacco.
The reason those companies can currently pay big dividends is because they have a competitive advantage in a sector with large, ongoing customer demand.
When looking for dividend shares to own in my Stocks and Shares ISA, I hunt for those attributes. I also consider the likely future demand picture (for example, falling cigarette sales could hurt British American Tobacco’s profits) as well as debt.
Invest then earn
The price I pay for a share helps determine the yield I earn. If I overpay and the share price later falls, the capital value of my Stocks and Shares ISA could decline.
With income as my objective, a fluctuating ISA valuation would not bother me. After all, if I hang on to the shares to earn dividends, that would just be a paper loss.
Still, I would prefer only to buy shares at attractive valuations. Finding companies that have strong dividend potential is not enough on its own. I also want to buy them at the right price.
That means I would not necessarily invest all of the £20,000 straight away, although at current valuations I would be happy to buy the trio of FTSE 100 shares above for my ISA if I had spare cash to invest.
I would also look beyond the FTSE 100 to the FTSE 250. But my focus would stay the same — high-quality businesses with attractive valuations.
