Generating passive income from dividend stocks might sound quite simple. After all, if I buy a stock and become a shareholder, I’m entitled to some of the dividends that are paid out. As long as I hold on to my investment, I should be guaranteed a regular stream of income. I don’t need to actually run the business (this is left to the directors), so it’s passive income by its very nature.
All of that is true, but I don’t want to be fooled. There are still several common mistakes I need to look out for when becoming an income-driven investor.
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Dividends and yields can change
First up is the misconception that the dividend is guaranteed. It’s not. Unlike a bondholder who needs to receive the coupon otherwise the bond is in default, shareholders aren’t certain that a dividend will be paid. A dividend is usually paid out from the profits from the previous year. So it all depends on how well the company has done during that period.
Over the course of the last year, this common mistake has been flagged up. A lot of large FTSE 100 companies had to cut or axe dividends, as the impact of the pandemic saw high losses generated. So my passive income from stocks can fluctuate.
Another mistake I need to watch out for is getting too attached to a dividend yield. The dividend yield is the ratio of the dividend per share relative to the share price. It works out to be a percentage, which I can then easily use to compare to alternatives when thinking about the passive income from stocks. However, even after I buy a stock, the dividend yield can change.
So if I buy a stock and the current dividend yield is 5%, this is great. But if the dividend amount changes (as mentioned above) or the share price fluctuates, the yield also changes. Therefore, it’s not accurate to say that I’ll get a 5% yield all the way into the future (but hopefully, my yield gets better and the passive income actually increases!)
Looking beyond the passive income from stocks
I also need to make sure that my focus on making passive income doesn’t leave me blind to the actual company I’m buying in to. I want to do my research so that I’m happy with the outlook for the business. That way, even if something happens to the dividend, I’ve got some potential growth from the share price to look forward to.
In some cases, I can get the best of both worlds. This is when I buy into a company that’s got a rising share price and is also paying out a generous amount in dividends.
One final common mistake I’m careful of is what to do with the passive income initially. If I don’t need to spend it straight away, I’m much better off reinvesting the dividend as soon as I get it. This will allow my money to compound over time. It’ll give me a much larger pot that’s generating income for when I need it in the future. If I just take the income now and leave it in my bank account, I’ll be losing out on this benefit.
The post 4 common mistakes I’d avoid when trying to make passive income from dividend stocks appeared first on The Motley Fool UK.
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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.
Motley Fool UK 2021