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How I’m aiming for £500 a month in passive income from dividend stocks

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Passive income from dividend stocks. Who wouldn’t like that? It’s certainly something I’m keen to achieve.

That’s why I’m aiming to build a portfolio of shares capable of delivering £500 a month in passive dividend income. It could potentially provide a valuable component of my income in retirement. And I’m planning to achieve it by investing in – wait for it – dividend stocks!

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Slow and steady can win the race

I reckon a strategy based around reinvesting dividends is hard to beat. Slow but steady gains can compound into meaningful progress over time. However, nothing is certain in the stock market and all shares carry risks. It’s possible for me to reinvest dividends for years and still lose money if I pick the wrong shares in the first place.

But what are the wrong shares for a dividend-based investment strategy? For me, they are shares with too much potential for dividend cuts, deletions, or setbacks. But it’s not always obvious which ones to avoid because some high dividend stocks have well-known and respectable businesses.

Take the banks such as Lloyds, NatWest, and Barclays for instance. Despite their chunky yields, they’d never make it into my long-term dividend portfolio. The cyclicality in the industry is massive. And bank stocks can deliver famine or feast outcomes for investors. The dividend is often an early casualty when bank stocks are heading into a general economic slowdown.

But cyclical sectors aren’t the only areas to avoid. I tend to view any dividend yield above 7% with suspicion. Often a high yield like that can be more of a warning than an attraction. Rather than troubled businesses, I look for dividends backed by strong and stable enterprises operating in defensive sectors. Indeed, the least cyclicality there is in the firm’s operations, the better.

That means I’m often searching in sectors such as utilities, energy, fast-moving-consumer goods, food supply, IT, technology, and others. But that’s not enough qualification on its own. As well as operating in a defensive sector, a business must have strong finances, a decent record of trading, and decent forward-looking prospects. Only then will I become interested in a dividend stock.

Compounding gains from dividend stocks

And it almost goes without saying that the valuation must be attractive before I’ll buy. But pinning down a decent dividend yield is often halfway towards finding an attractive valuation. And that’s one strength of the strategy.

The process of compounding works exponentially over time. And that’s why my plan involves compounding dividends and other gains for a long time. In the later years of a programme of compounding steady gains, the annual gains can be meaningful. And they need to be. Because £500 a month passive income from dividend stocks requires a share portfolio worth around £150,000 by my estimate. That’s assuming an overall dividend yield of 4%, which seems realistic.

However, I believe it can be achieved by people like me on an average salary. And the key is for me to start the compounding process as soon as possible and to keep going.

Here's a good place to start my research:

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. 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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