The Motley Fool

3 mistakes to avoid when seeking to generate a passive income from dividend stocks

Obtaining a growing passive income from dividend stocks can be achieved by any investor. Indeed, with global stock markets having come under pressure in recent months, the opportunities to do so may be more appealing than they have been for some time.

However, there are a number of pitfalls facing income investors that could derail their potential to build a sound dividend-focused portfolio.

Notably, concentrating solely on dividend yields rather than growth potential, buying cyclical stocks which lack robust earnings prospects and failing to diversify in order to reduce risk could hurt your prospects of obtaining a passive income.

By avoiding those potential mistakes, you may be able to generate a faster-growing and more reliable income return from dividend stocks.

Dividend yields

While a high dividend yield is clearly preferable to a lower income return, failing to consider the future prospects for a company’s shareholder payouts could be a major mistake. After all, a high yield without future growth may mean that, over the long run, an investor’s portfolio fails to deliver an increase in spending power that is required in order to maintain their current lifestyle.

As such, considering the potential for dividend growth and the affordability of shareholder payouts could be a good idea for any income investor. In fact, doing so may prove to be more important than considering a company’s dividend yield, since a rapidly-growing dividend could lead to a rising stock price as investor interest in a stock increases.

Cyclical stocks

While cyclical companies provide an opportunity for investors to buy low and sell high, their income investing prospects may be less appealing. After all, by their very nature cyclical companies experience highly challenging periods that can equate to slower dividend growth. In some cases, dividends may be cut due to a fall in profitability, for example during an economic slowdown or recession.

Therefore, investors who are seeking to build a robust and reliable passive-income stream may wish to focus on defensive stocks with solid track records of dividend payouts. While they may not offer the high rate of dividend growth produced by cyclical companies during boom periods, in the long run their overall income returns may prove to be more sustainable.

Diversity

Buying a small number of dividend stocks exposes an investor to a significant amount of company-specific risk. In other words, should one of their holdings experience a difficult financial period and be forced to cut dividends, it would impact negatively on their portfolio income returns in a given year.

As such, buying a wide range of companies that operate in a number of different geographies and sectors could be a worthwhile move. This may produce smoother income returns, as well as a more reliable passive income, that could grow at a relatively fast pace due to its exposure to a variety of industries and regions.

High-Yield Hidden Star?

Discover the name of a Top Income Share with a juicy 7% forecast dividend yield that has got our Motley Fool UK analyst champing at the bit! Find out why he thinks “the stock’s current weakness may offer us the chance to buy a proven dividend performer at what could be a bargain price”. Click here to claim your copy of this special report now — free of charge!