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Best practices for earning passive income through dividend shares

I first heard the phrase ‘passive income’ a few years ago, though unknowingly I had been partaking in it for many years before that. As the name suggests, it is any way that can earn you money with little or no active effort on your part.

Though the phrase traditionally refers to investments like bonds, I believe one of the best ways to earn passive income is through investing in shares.

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Dividends please

Investing in stocks derives income from dividends – a share of profits made by a company and paid to its shareholders (the money earned through buying and selling the shares at different prices is capital gains, not income).

Not all stocks pay dividends, and unlike a bond where the return is fixed at the time of investment (hence the title, fixed income), a dividend is actually paid in pence per share – meaning the percentage return on your investment – the dividend yield – is highly dependent on the share price.

The same share, paying the same exact dividend, could yield you 6% annual returns if you invest in a bad month (for the company’s share price), and 3% in a good month for the stock (this change would actually represent a doubling of the share price between the bad and good month).

Your investment can go down as well as up

The major hurdle for many when it comes to using shares as a means of passive income is the risk to the initial capital. This is a fair point, and if you want zero risk with your investment, then shares are not for you. It is, however, possible to manage and even minimise the risk associated with buying shares, through a number of precautions.

The first and most obvious for any investor looking for minimal risk is stick to investing in the big blue chip companies. While there is no guarantee even with large firms, well-established, strong companies with large market capital and a good brand are generally less volatile in their price and less likely to go bust.

Even with this though, one should look for investing advice when it comes to stock picking, as even a company that pays a massive dividend yield won’t give you good returns if its value halves after a year. A general rule of thumb for time frames when investing is to expect to hold a position for at least five years.

Over this kind of period, short-term fluctuations based on headline news events tend to even out.

The other major piece of advice I would give to minimise risk is to diversify your portfolio – that is to say, invest in shares across a number of industries. Spreading yourself thin like this is not a particularly good way to make capital gains, but if only considering income, one can easily find many companies offering you the kind of yield you are looking for.

Again a good rule of thumb is to invest in at least six companies – at the very most 15 – with the ideal around the 10 figure. With some sensible decision-making and good advice, earning passive income through shares is not as scary as it may at first seem.

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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.