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The idea of earning a second income by investing in shares has a few advantages.
I can benefit from the hard work and expertise of large, proven businesses like Tesco and Vodafone. Helpfully, I can do so even if I have only limited funds to invest.
If I had a spare £5 a day to put towards building a second income, here is how I would go about it.
Regular saving habit
A fiver a day may not sound like a lot – but it adds up.
In a year, saving that amount would give me over £1,800 to invest. Over a decade, putting aside £5 every day would mean I had over £18,000 to put to work in the stock market.
I would aim to get into a regular habit. To do that, I would set up a share-dealing account or Stocks and Shares ISA.
Dividend source
My second income would come in the form of dividends.
When a company makes a profit, it can reinvest the money in its business or share it out among shareholders. Dividends are basically a way in which shareholders can financially benefit from a company generating excess cash.
So, when looking for companies I think might pay me big dividends in future, I consider their business models. Do they have some sort of unique attribute like the technology of Microsoft or brands such as Guinness brewer Diageo?
What about a firm’s balance sheet? If a company has large debts to service, it could mean that even big profits do not end up funding dividends.
Share valuation and yield
Even when I find a business I like, I will not add its shares to my portfolio unless I think the valuation is attractive.
After all, although my focus here is on building a second income, I would also hope to reduce the risk of capital loss. If I buy shares that are priced too high, I may earn dividends from them but find that in future if I sell the shares I get less for them than I paid.
Valuation also matters because the price I pay for a share helps determine the dividend yield I will earn from it.
Yield is an indication of how much second income I can earn in a year. If I invest £1,825 (a year’s savings of £5 daily) at a 5% yield, I could earn £91 in dividends annually. At a 10% yield, though, I would earn twice as much.
Long-term approach
Not many blue-chip FTSE 100 shares pay a 10% yield but there are some. Vodafone, for example, yields 11% at its current share price.
Indeed, I think some UK share price valuations (and therefore dividend yields) are currently very attractive, which is why now could be a rewarding time to start building a portfolio to generate a second income.
