Dividend investing could be the key to creating a passive income stream.

Here’s how I’d approach this challenge.

Steps I’d follow

As dividends are the foundation of my target, I need to ensure I buy stocks in the best investment vehicle. For me, this is a Stocks and Shares ISA. This is due to favourable tax implications on dividends received, as well as a generous £20K annual allowance.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Let’s move onto stock picking. When it comes to dividend investing, high yields aren’t always what they seem. So, I’m looking for industry leaders, good financial health – a balance sheet can tell me this – as well as a payout record. Finally, I want to ensure I’m receiving dividends for a long time, so I’d look at whether or not a stock I’m considering is future proof. Plus, I’d diversify my holdings, as this is an excellent way to mitigate risk.

Quick maths

Let’s say I had £10k in the bank I wanted to use to kick things off. In addition to this, I’d also invest £250 per month from my wages. I’m looking to invest for 25 years and aiming for an 8% rate of return.

The magic of compounding would help me build a nice pot. After 25 years, I’d be left with £311,158. If I draw down 6% annually, I’d have a five-figure passive income stream worth over £18,000 annually to spend on whatever my heart desires.

Risks to note

The biggest issue with my plan is that dividends can always be cut or even cancelled. Each stock I buy comes with its own risks that could dent earnings and lead to a need to conserve cash. This is why I class stock-picking as the trickiest and most time-consuming part of this plan.

Finally, 8% is my target yield, but I could earn less than this. If this is the case, I could be left with less to draw down from when the time comes.

One stock I’d buy

If I was following this plan today, I’d buy Phoenix Group Holdings (LSE: PHNX) shares.

Phoenix is the UK’s largest long-term savings and retirement business. Ironically, as I’m thinking about my retirement finances, this is exactly what Phoenix does for its customers, and it has been doing for many decades.

From a bullish view, Phoenix’s market dominance, as well as past track record of performance, are excellent. Although I do understand that the past isn’t a guarantee of the future, analysts and the business itself are forecasting fruitful times ahead.

At present, the shares offer a dividend yield of over 9%. For context, this is higher than my target yield, as well as the FTSE 100 average of 3.6%.

The risks for Phoenix – aside from being in an ultra-competitive sector – are that during times of economic volatility, like now, spending on non-essential policies can take a hit. This can impact earnings and returns. I’d keep an eye on this.

Overall, a great market position, good track record, solid future prospects, and a fantastic level of return help me make my decision today.