Using dividend stocks as part of passive income investing is becoming increasingly popular. It’s something that I do and something I should really do more of with my cash! In a low-interest-rate environment, there’s a high opportunity cost of not making my money help make me more money. But the rush to simply find a home for my cash via dividend stocks can lead me to make unnecessary mistakes. This is something I need to be careful of.
Having the right expectations for income investing
One of the common mistakes I see with passive income investing is simply trying to target the highest possible income payment from a stock. Simply looking at the highest dividend per share as a monetary figure is not always wise. For example, if I buy a stock with a share price of 100p and a dividend per share of 10p, my yield is 10%. But what if the dividend per share is 10p, but the share price is actually 1,000p? Then my yield is only 1%.
So just looking at the dividend per share isn’t a true reflection of the overall return for this part of my passive income investment. A better way is to look at the dividend yield, which factors in the share price to provide a percentage yield. This yield still changes every day, but gives me a better comparable number to work with compared to other dividend stocks.
A second common mistake I could make would be to think that all the future dividend income is guaranteed. As much as I’d like to plan for years ahead how much passive income my stocks will definitely make me, it’s not always possible.
I do always try to find dividend stocks that historically have been paying out regular dividends. Yet unexpected company-specific events, or a wider problem (like Covid-19), can impact things. This could cause the dividend to be reduced, lowering my income in this regard.
By knowing that this can happen I can reduce the surprise here, and ensure that any projections I do take into account a margin of error.
Diversifying my stocks
The final mistake I’m wary of making is putting all my eggs in one basket. I might find a company with a great outlook and a strong track record of paying dividends. Even in this case, I’d be making a mistake to just buy this one stock in my portfolio for passive income investments.
Buying multiple shares helps to spread out my risk and also my overall yield. For example, I might decide to buy a slightly-high-risk stock with a generous yield of 8%. If I supplement this with a low-risk, stable stock offering a yield of 4%, then it enables me to reduce my risk. At the same time, my yields blend together, giving me a higher yield than just picking low-risk companies.
The more money I’m looking to invest, the more stocks I’d look to buy to spread the risk.
Overall, passive income investing isn’t a new concept, and so hopefully I can learn from these mistakes going forward.
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jonathansmith1 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.