Building up passive income is the goal of many investors. Successfully generating a passive income can give you the financial freedom to change what you do with your life. It can lead to early retirement, more holidays, and even increased peace of mind.
Why dividend stocks?
I think dividend stocks are one of the best ways to create passive income. That’s because once you’ve bought your stocks, you can keep enjoying the dividend income for life. Really there’s only two things I worry about. The first is deciding how much of my dividends I should reinvest to take advantage of compound interest.
And the second is keeping an eye on my holdings, just in case I might need to sell. To reduce this burden, it’s important to try to pick stocks that will generate steady returns over many years. This doesn’t mean the stocks with the highest dividend yields right now. That’s because then I’d have to actively manage my portfolio in case the dividend drops. Instead, to create income that’s truly passive, the highest yield dividend stocks have to be ignored in favour of the most reliable ones.
Investing in a FTSE 100 tracker fund would yield about 3.4% this year. As a baseline, this is a far better return than any cash savings account I could get right now. But what I’m looking for are stable share prices with yields that beat the FTSE 100 average.
Truly passive income stocks
1) Aviva has a current dividend yield of 5.3%. At 400p today, it’s recovered from the mini-crash of March 2020, and it’s averaged 422p over the past five years. It’s an insurance provider, and that’s what makes it attractive to me as a passive income stock. That’s millions of us making regular home, life, car, and pet insurance payments every month. And I don’t think that’s ever going to change. The company has also been exiting European and Asian operations, most recently divesting its last European business, Aviva Poland, for £2.1bn. In total, this has generated £7.5m. And a “substantial portion” is to be returned to investors.
2) National Grid has a dividend yield of 5.4%. Its share price is 891p, against a five-year average of 906p. Spanning the US and the UK, the utility company supplies gas and electricity to millions of customers. Encouragingly for a passive income stock, it’s future-proofing. It launched a $250m technology fund in 2018 to invest in green energy alternatives. And having received regulator approval, it’s buying Western Power Distribution, the largest electricity distribution company in the UK. Of course, rocketing gas prices are a concern, as is the small risk that utilities could be nationalised.
3) Tesco has a dividend yield of 4%. Its share price is 254p against a five-year average of 271p. It’s the UK’s largest grocery retailer, having cornered over a quarter of the available market share. Food, like insurance and energy, is something we can’t live without. I’m confident that this retailer will continue to pay strong dividends for years to come. It is having supply chain issues caused by the HGV driver shortage, which could eat into its important Christmas income. But it’s my third stock choice I think I could buy and derive passive income from forever.
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Charles Archer owns shares of Aviva. The Motley Fool UK has recommended National Grid and Tesco. 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.