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Supplementing your pension with passive income

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Passive income has been a buzzword for the past few years. It can take many forms, from publishing a book to starting a business. For me though, the stock market is one of the best and easiest ways to gain a passive income. 

The basic premise

Passive income, as the name suggests, is an attempt to receive money with little or no on-going efforts. For many it is the dream – having enough cash coming in to mean they can quit their job and retire early. Images of sitting on a sandy beach sipping champagne come to mind.

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Of course gaining this level of passive income can be very difficult. Starting a business or publishing a book may not be suitable for many. And even if it is, there is no guarantee it will be successful.

Though it often doesn’t get mentioned in the same context, millions of people have been making passive income for decades — long before the term itself was used. This passive income comes from investing.

Though fixed income bonds offer a guaranteed (assuming they don’t default) return, with interest rates as low as they are right now, this is negligible. The stock market, however, can offer much better returns through dividends.

Dividends as passive income

First a few caveats. The stock market, of course, has many price fluctuations. If you buy a share today for its dividend, tomorrow it could be worth half its value if something goes very wrong. No dividend will make up for that.

In addition, unlike bonds, the return from a stock is not guaranteed over any significant period. If a company makes less money, it can reduce or even suspend its dividend. Luckily these risks can be mitigated by sensible decisions and good advice.

Top tips for dividend investing

First, plan on investing for the long term. If you can’t afford to lock your money away for five years or more, short-term price fluctuations may be too much for you. Even the best companies will see their prices go down sometimes. You need to be able to hold on when they do.

To help with this, look mainly at big, blue-chip stocks, preferably companies with strong brands. Though it’s no guarantee, larger, well-established firms are better able to weather financial turmoil. They also tend to have more cash available for investors.

To help in stock choice, look for companies that have paid dividends consistently for, say, five years. If a company has a dividend one year, none the next, half again this year, it is probably not the right choice.

You also want to look for a share that has also grown its dividend over time. Inflation-beating growth should be enough.

The last consideration is in many ways the key one: yield. While five-year bonds are only paying a few percentage points, it is quite easy to find solid shares paying 5% or more.

Ideally look for stocks with a dividend yield between 3% and 6%. Anything less isn’t worth it, and anything more may be unsustainable.

However, keep in mind that a dividend yield is based on the share price. An oversold stock will mean an artificially inflated yield. Always be on the look out for these kinds of opportunities to boost your passive income for less.

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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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