£1,000 each year in passive income would come in quite handy for me. I have a plan to achieve that by investing in UK dividend stocks. Here’s how.
What are dividend stocks?
When companies generate profits, they can use it in a few ways. Sometimes, they will pay off existing debt. Saga is an example of a company which doesn’t plan to pay a dividend for several years, as it has significant debt on its balance sheet. Often companies will use surplus cash to invest in growth. Fast expanding firms like S4 Capital and THG don’t pay dividends because they believe they can use the money to grow their businesses.
But often, companies will pay out at least some of the money as dividends. These are payments a company makes to shareholders, based on the size of their shareholding. A business that generates a lot of cash but lacks attractive growth opportunities is a classic example of a dividend stock. Such UK dividend stocks include British American Tobacco and National Grid.
UK dividend stocks as passive income streams
These dividends could form a passive income stream. That’s how I hope to generate £1,000 a year by sitting back and waiting for the dividends to roll in. Of course, there’s always a risk that dividends won’t be paid.
For example, a company could reduce its dividend as it reorganises its business, like Imperial Brands did last year. It could cut the dividend while business is tough, as Babcock has done. It could also simply decide to stop paying dividends altogether for a while.
To mitigate this risk, I invest in a variety of UK dividend stocks. That diversification isn’t limited to individual shares – I also make sure I invest across a number of different business sectors.
My £1,000 passive income plan
The FTSE 100 yield averages around 3%. So to achieve £1,000 a year in dividend income at that rate, I would be looking at an investing pot of around £33,400. Could I achieve my passive income with less? I think I could.
My plan would be to invest in shares that pay out a higher dividend yield than the average. Fortunately, there’s no shortage of such shares. For example, British American Tobacco pays out 7.5%, M&G also yields 7.5% and the payout on Legal & General equates to 6.4% at the current share price.
If I can select a diversified group of shares with an average yield of 7%, for example, I’d hope to generate £1,000 annually in passive income with a pot of less than £15,000.
Risks in UK dividend stocks
But why would shares yield more than double the average?
One explanation is that the 3% average figure is skewed by growth stocks that don’t pay dividends. So quite a few dividend stocks offer a higher dividend yield than the average.
But high dividends can also signal a market assessment of risk. The market may think that a company’s future prospects look dim. There’s a risk that smaller profits could lead to dividend cuts.
Yet if I diversify my portfolio and only invest in what I think are attractive companies (rather than focusing just on yield), I hope to minimise that risk. With an initial capital investment, or a pot built up over time, I hope to generate £1,000 annually from my portfolio of UK dividend stocks.
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christopherruane owns shares of Babcock International Group, British American Tobacco, Imperial Brands, and S4 Capital plc. The Motley Fool UK has recommended Imperial Brands. 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.
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