I’d invest £500 a month to target a £45,000 second income from dividend shares

Even though the recent stock market rally has pumped up the valuations of leading dividend shares, there are still plenty of UK income stocks trading at good prices. Building a diversified portfolio of high-quality businesses today could lead to a surprisingly large nest egg for a more comfortable retirement.

In fact, drip-feeding just £500 a month into the stock market could produce a seven-figure portfolio generating £45,000 in annual passive income. Here’s how.

Finding high-quality dividend shares

As previously mentioned, not every dividend-paying stock has recovered from the 2022 correction. And for investors brave enough to buy these discounted shares even with all the economic uncertainty, greater wealth can potentially be unlocked in the long run.

However, it’s essential to avoid falling into classic income traps. While the adverse macroeconomic environment is already improving, its short-term effects might have permanently damaged certain businesses. Even the firms whose operational cash flows have already recovered may be in trouble if their balance sheets are riddled with debt.

After all, rising interest rates make servicing loan obligations more expensive, with fewer financial resources left over to fund payouts from dividend shares. But for the companies still in robust shape, these short-term disruptions may soon be over, paving the way for prosperity as overleveraged rival firms struggle to get back on their feet.

Turning £500 into £45,000

Looking at the FTSE 100, the average dividend yield among the largest listed enterprises in the UK currently stands at roughly 3.5%. Therefore, to generate £45,000 from 3.5%, an investor will need a portfolio worth just over £1.28m.

Needless to say, that’s not exactly loose change. But as crazy as it may seem, consistently investing £500 each month can establish a nest egg of this size in the long run. To accelerate the process, investors can turn to a more growth-focused index such as the FTSE 250.

Historically it has produced average annualised returns of 10.6%. And investing £500 a month at this rate would theoretically result in a portfolio worth £1.29m in just under 30 years. This could potentially unlock an earlier retirement for individuals in the early years of their careers.

When the threshold is hit, investors can reallocate their capital to the FTSE 100 index and reap an annual 3.5% yield. Alternatively, they could choose to pick individual dividend shares to increase their passive income stream. Even if the portfolio yield grows to just 4%, that’s an extra £6,200 a year.

Nothing is risk-free

As exciting as the prospect of earning nearly double the average UK salary in passive income is, it’s important to remember that the stock market can be volatile.

There’s no guarantee that indexes’ past performance or dividend yields will continue for the next three decades. Moreover, crashes and corrections occasionally rear their ugly heads, disrupting the wealth-building process. And depending on the timing of these events, an investor may end up with considerably less than expected.

Nevertheless, the potential rewards of dividend shares make these risks worth taking, in my opinion.