The idea of using passive income to make money while sleeping sounds fantastic to me. And as Warren Buffett once said: “If you don’t find a way to make money while you sleep, you will work until you die”.
Many companies’ share prices have yet to recover from the market crash in March last year. Including some businesses that will prosper in future. As a result, yields of around 4% are quite widely available and could be used to build a substantial source of passive income. Several stocks today even offer higher yields, even close to 10%, although these are much more risky.
Using dividend shares to earn passive income
There are lots of different investment instruments that can generate passive income. In the late 1980s, bonds were very popular and carried minimal investment risk. But the low-risk ones offer very low rewards today.
That’s why I like dividend stocks instead. Shareholders receive cheques every couple of months, for doing absolutely nothing. They can spend their time playing games, going for a walk, or in my case, taking a nap. Meanwhile, the money keeps on rolling in.
But as wonderful as this prospect is, stocks carry significantly more risk than bonds or cash.
Dividends can disappear!
Because dividends are paid from a company’s profits, their fate is ultimately tied to that company’s success. When trouble lies ahead, and cash needs to be preserved, dividends are usually on the list of expenses to cut, delay, or even cancel.
Just look at what happened last year. Over 500 UK stocks cut or cancelled dividend payments following the first lockdown in March 2020.
Sometimes a firm will take out loans to maintain dividend payments in times of crisis. But this is ultimately an unsustainable and dangerous approach to pleasing investors. It burdens a company’s balance sheet with debt, resulting in higher interest payments that damage its financial health. Needless to say, it’s a giant red flag in my eyes.
Finding the best and sustainable dividend stocks
There’s no point in buying shares in a stock that pays a high dividend yield if that yield disappears in the future. This is commonly known as a yield trap. Therefore, I believe avoiding these traps is the key to building a reliable passive income portfolio.
The good news is, most of the time they aren’t that hard to spot. Let’s say I’ve discovered a dividend stock that pays an impressive 10% yield. By comparison, in the UK the average is around 4%. Is this a trap? Possibly, but more information is needed.
Looking at a historical price chart, it’s likely I’d see a sharp decline in share price within the past few months. Because remember, when the share price falls, the yield percentage relative to it will go up. So the question is, why did the share price fall? There’s usually more than one answer. But if it’s primarily due to a temporary problem that can be solved, such as a market crash, then I might have found a fantastic passive income opportunity.
Investing in the stock market can be a risky endeavour. But if I mix riskier stocks paying very high yields with those paying less spectacular percentages, I think the rewards can balance the risks (which both diversification and research can help to reduce).