Investing a lump sum is one way of establishing passive income from dividend-paying shares. But it’s not the only way. And it may not even be the best way.
One of the pitfalls of investing money all at once is the possibility of buying stocks in an over-valued market. And we’ve seen during the past few months how stocks can fall by substantial percentages if they become over-valued.
Investing in stages
So it can sometimes work out better to invest money in stages. And for me, a monthly investment works well because my income arrives monthly. Therefore, it’s a simple process to divert some of that into my investment portfolio.
The great thing about investing regularly is it reduces the danger of buying stocks in a toppy market. I’ll be investing money in all market conditions, including when stocks are undervaluing their underlying businesses. And overall, the effect can be to smooth out some of the volatility that comes with the stock market.
And the weakness in many share prices lately makes it a great time to begin a programme of regular investment into stocks. Meanwhile, £35 a week works out at just under £152 a month, which is a worthwhile sum to invest. And it’s only the equivalent of £5 a day, something I’d hardly miss.
The process of compounding
But over time, the process of compounding gains has the potential to drive substantial rises in the value of a stock portfolio. Billionaire investor Warren Buffett pointed out that America’s S&P 500 index has been delivering compounded annual growth of around 10% a year for decades. So one approach I could use is to simply put regular money into a spread of low-cost index tracker funds.
I’d make sure that the dividends are automatically reinvested to ensure compounding is maximised. I want passive income streams to draw upon, yes, but not yet. First, the portfolio needs to build so that the eventual dividend income is as big as it can be. Perhaps I’ll draw on it in retirement, for example.
Individual company shares
But investing directly in the dividend-paying shares could be even more lucrative because many pay higher dividends than the combined yield of a stock index. And, again, I’d reinvest those dividends to boost the compounding effect.
However, it’s worth remembering that dividend income is never guaranteed. Company directors have the power to trim or stop dividends whenever they choose. And they often do so if a business runs into operational challenges.
Nevertheless, the stock market has a good long-term record. And its returns have beaten other major classes of assets, such as bonds and cash savings. So I’d aim for my programme of investment to last for my entire working life. And I’d aim for those dividend income streams to continue hitting my bank account for the rest of my life after that.
Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.