I’d follow Warren Buffett to target effortless passive income

Warren Buffett knows a thing or two about building passive income streams. By learning from the Sage of Omaha, so too does our writer!

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Buffett at the BRK AGM

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Imagine earning over a million pounds a day on average in passive income from a single shareholding. Legendary investor Warren Buffett does not need to imagine that. His company Berkshire Hathaway receives that much in dividends simply from one of its holdings, Coca-Cola (NYSE: KO).

My own passive income streams will never be anything like that large. But I still think I can learn from Buffett when it comes to building them.

Here are a few simple lessons from investing the Buffett way I believe can help me build income streams that are genuinely passive and do not require me to work hard.

Invest for the long term

The Coke stake is lucrative for Buffett and it has become more so over time. The company is a Dividend Aristocrat, having raised its dividend annually for over half a century.

So although the last time Buffett bought a Coke share was decades ago, his income streams from the shareholding have grown regularly over time.

Taking a long-term approach to investing can pay dividends – not only metaphorically, but literally!

Avoiding yield traps

Some investors make the mistake of thinking a share that has a high dividend yield today will necessarily be a lucrative source of passive income.

But dividends are never guaranteed. Indeed, a high yield can sometimes reflect City fears that a company’s business might not support the sort of dividends in future that it pays now.

Think about where income comes from

Again, Buffett’s choice of Coca-Cola is instructive. It serves a large market that is likely to stay big, in the form of soft drinks. Its iconic brand and proprietary formula give the company a sustainable advantage over rivals.

The product is cheap to make but can be sold at a premium price, helping the business generate spare cash it can use to fund dividends.

That has been true in the past – but it also seems likely to be the case in the future. Of course, it may not. For example, growing health consciousness could hurt profits. Then again, this might open up opportunities for new products.

Like Buffett, when assessing the passive income streams a share might generate for me, I do not focus only on its dividend history. I think about how the business can generate income in the future.

Compounding dividends

Although Buffett has set up massive dividend income streams, Berkshire does not pay a dividend. Instead, it puts the money it earns to work by buying new shares and businesses.

As a private investor, I can do the same simply by compounding my dividends. That may reduce (or eliminate) the passive income I earn from shares for now. But it could lead to bigger passive income streams down the line.  

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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