Warren Buffett says that those who don’t find ways to make money while they sleep will work until they die. But investing in dividend shares can be a great way of earning passive income.
Investing in the stock market isn’t easy and returns are never guaranteed. But avoiding some key mistakes can give investors the best chance of boosting their income for the long term.
Mistake 1: only looking at the dividend yield
Several UK stocks have eye-catching dividends. And when shares in British American Tobacco (LSE:BATS) come with a yield approaching 8%, it can be hard to think of much else.
Reinvesting dividends at 8% a year is enough to turn £10,000 today into something that pays out £3,775 a year in 2044. That’s a pretty nice return.
But investors need to think about whether the company’s going to make enough money to keep paying that dividend for 20 years. Especially with cigarette volumes declining.
I’m not saying this won’t happen. But anyone considering buying the stock for long-term passive income should think about how far new products might replace lost revenues.
Mistake 2: not diversifying enough
Another big mistake when it comes to passive income is not diversifying. This can leave a portfolio vulnerable to specific risks, having a disproportionate effect on overall returns.
For example, British American Tobacco generates the majority of its revenues from outside the UK. That contrasts with Taylor Wimpey, which is heavily exposed to the UK economy.
This makes a recession a potential risk (though it may be one that investors consider worth taking). But owning shares in British American Tobacco limits the overall effect on a portfolio.
Diversification doesn’t have to mean owning 50 or 100 stocks. But investors should think carefully about how far the companies they own shares in are vulnerable to the same risks.
Mistake 3: just looking at the past
Whether it’s dividend investing or anything else, it’s easy to try and build a view on where a company’s going based on where it’s been. But this is generally a bad idea.
In a lot of industries, things can change suddenly. For example, pharmaceutical firms like GSK can find profits drop sharply when patents protecting drugs expire.
This can potentially put dividends at risk. And it generally doesn’t show up on a company’s income statement until it’s too late to do anything about it.
With this type of stock, what matters is its pipeline of new drugs that are making their way through the testing process. So investors need to look at this, not just the firm’s track record.
Dividend investing
I think the stock market’s a great place to find passive income opportunities. But investors need to have their eyes open before considering buying any shares.
Even if the focus is passive income, finding stocks to buy involves looking beyond the dividend yield. And understanding where the business is going as well as where it’s been is crucial.
Thinking carefully about how to build a diversified portfolio is also important. But for investors that can get this right, the potential rewards can be huge over time.
