People often look for passive income as a way to improve their financial situation. But many passive income plans require lots of money to start with — which many people do not have. That is one reason I like the approach of investing in dividend shares. I could do that beginning with nothing, and using just a few pounds a day to build up my income-generating resources.
Here is an example that requires me to put aside £5 a day.
Building up investment funds
To buy dividend shares, I will need money. That is where the £5 a day comes in. I can save that up, day after day and week after week. It should soon start to pile up. Over a year, that level of daily saving adds up to over £1,800.
The regular discipline should help me get into a habit and hopefully barely notice that I have £5 a day less in my wallet. But starting to build up these investment funds is critical. It will be the foundation of my long-term passive income plan.
Investing in dividend shares
That income will hopefully come in the form of dividends from companies. Not all listed firms pay dividends – and their historic performance is no guarantee of what they will do next.
So, when looking for dividend shares to buy, I would hunt for companies with business models I reckon ought to help them generate large free cash flows in the years to come. Such free cash flows could be paid out to shareholders as dividends in future.
For example, electricity distributor National Grid has limited competition and demand for electricity distribution should remain robust. Cigarette maker British American Tobacco has been mitigating the risk of declining cigarette volumes by raising prices, as well as introducing new product formats. Insurer Legal & General has an iconic brand in a market that I expect to continue seeing strong demand.
But things can always go wrong, sometimes in ways no one expects. Maybe shifting patterns of electricity use will mean National Grid needs to boost spending on its infrastructure, for example, hurting profits. Legal & General could see its profits suffer if a new market entrant starts a price war to attract customers. So, I would diversify my portfolio across different companies and business sectors. That way, if one of them suddenly cuts or cancels its dividend, the impact on my overall portfolio will be reduced.
Is this a viable passive income plan?
If I invested one year’s savings in a diverse portfolio of dividend shares yielding an average of 4% (meaning their annual dividend was 4% of what I paid for the shares), I would expect passive income of around £73 per year.
I could try to get more by investing in higher-yielding shares. But sometimes high yields signal an elevated risk, so I would need to do my research carefully. Remember, my priority is finding companies with resilient business models that I think could generate substantial free cash flows for years to come.
Over time, hopefully, this straightforward passive income plan would see me grow my earnings without needing to work for them. But one thing I need to do is make a start. If it stays as a plan, without being put into action, it will not earn me even a penny of passive income.
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Christopher Ruane owns shares in British American Tobacco. The Motley Fool UK has recommended British American Tobacco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.