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An easy way to earn a second income is to create a portfolio of dividend stocks.
Not only does this involve little actual work, but it can also be lucrative. Step by step, here's how an investor could use that strategy to reach £10,000 in passive income each year.
A lump sum is an option, but not necessary
Dividend income will depend on how much is invested and what the average dividend yield is.
For example, using a 5% dividend yield, £10,000 in annual second income would require an investment of £200,000.
But an alternative method (and the one I use) is to try and reach the income goal over time making regular contributions to an ISA.
Even £200 a week compounded at 5% annually could result in a portfolio of £200,000. Sure, it would take 14 years. But as a long-term investor, that's music to my ears.
Find stocks to buy
An investor could also speed things up if the compound annual growth rate (i.e. share price movement plus dividends) was greater than 5%. But dividends are never guaranteed and share prices can go up or down.
That's why I never pick a stock just for its performance.
Rather, I try to find great companies that I believe have excellent long-term business prospects that, in my opinion, are not adequately reflected in their current share price.
A brief case study
That sounds good in theory, but what about in practice?
Let me illustrate with a stock I have: footwear specialist. crocodiles (NASDAQ:CROX). Over the past five years, Crocs' stock price has skyrocketed 149%: way, way above my example of 5% per year.
I have missed out on that gain, as I am a fairly new shareholder. Good. The thing is, even now, the company is trading at a P/E ratio of just 7.
That seems almost absurdly cheap to me given the iconic brand and product, huge customer base, manufacturing management expertise and proprietary designs. I don't like Crocs, but I know a great business model when I see one.
Still, if business is so good, why is it selling at that price and why is it down 36% since June?
Your acquisition of Hi, friend The footwear brand has brought a lot of problems and seems increasingly undervalued.
That's a risk to profits. But I still think Crocs is a great business at a great price and I plan to hold the stock.
Getting ready to invest
But wait. Crocs does not pay dividends. So where would a second income come from in such a scenario?
Remember earlier I talked about a £200,000 portfolio invested with a 5% return. If not starting with a lump sum, the investor does not need to invest in dividend stocks. immediately.
They can use a combination of dividends and growth stocks to increase the value of their portfolio. Then, at the £200,000 mark, they could switch to dividend-only shares.
If the investor diversifies and chooses the right stocks, that second £10,000 income will hopefully continue to come (and perhaps even grow) each year.
But they need a good way to buy and hold those shares, such as a stocks and Shares ISA.
