Dividend shares are an excellent way to earn a second income, in my opinion. And the UK’s FTSE 100 index holds dozens of them.
To create a passive income plan using these stocks, I’d first do some maths.
For instance, I’d want to know how much to invest, how long to invest it for and finally, what to invest it in.
Long-term approach
Let’s assume that I have £250 a month to put towards this plan. If my target is to earn almost £30,000 a year in dividend income, I have to note that it won’t happen straight away.
Some of the best income stocks in the FTSE 100 offer around 8% a year in dividends and I calculate that to reach my target income, I’d need a pot worth £340,000.
It may seem like a big number, but by adopting a long-term approach, I firmly believe it’s within reach for many people.
The magic of compounding
If I put £250 a month aside and wait until it reaches the required size, I’d take over 110 years to get there.
But if I were to invest it in the stock market, and reinvest the dividends, I calculate that it could take a third of the time.
To demonstrate, assume I spend £3,000 and buy 1,321 shares of a FTSE 100 dividend share like Legal & General. With a dividend yield of around 8%, by the end of the first year, I should earn £240 in dividend income.
By reinvesting this payout, I could buy 105 more shares. The following year, I’d earn dividends from both my old shares and my new ones.
This is the magic of compounding, and it’s also what Albert Einstein referred to as the eighth wonder of the world.
What could happen
| Years | Total pot | Annual income |
| 10 | £ 43,460 | £ 3,477 |
| 20 | £ 137,286 | £ 10,983 |
| 30 | £ 339,850 | £ 27,188 |
The table above shows how I’d expect my pot to grow over time and its corresponding annual income that I’d expect to receive. Note how my investment grows faster in its later years.
Although I could start withdrawing an income after 10 years, I’d be rewarded far more if I wait longer.
I assume that I’ll be able to achieve growth of 8% a year. That’s not guaranteed and I could get much less. But it’s the average return over several decades so I’d consider it a fairly safe assumption to make.
Which shares?
With a long-term investment, I’d diversify my selection to avoid putting all my eggs in one basket.
Diversification means to spread shares across industries and sectors.
If I had spare cash to devote to this long-term approach, I’d buy shares in Legal & General, Phoenix Group, Rio Tinto, British American Tobacco, and Persimmon.
On average, this selection offers an 8% dividend yield. Bear in mind there are other factors to consider too. For instance, I’d need to check that the dividends are affordable and sustainable.
Businesses can change over time too, so I’d need to monitor my selection to ensure they continue to perform.
All things considered, by adopting this long-term plan, I should be on the way to a five-figure second income.
