The mission to gain a source of passive income is shared by most individuals. And while there are plenty of ways to go about it, buying dividend stocks, in my opinion, is one of the best methods.
Historically, bonds have been seen as the go-to instrument for passive income investors. However, with interest rates slashed to nearly zero for over a decade, non-junk-rated bonds have struggled to provide returns greater than inflation.
However, today several FTSE 100 stocks are offering yields of over 10%. With that in mind, I think dividends look like a far more attractive and lucrative option to generate a passive income.
Passive income through dividends
As a quick reminder, paying dividends is the act of returning capital to shareholders when a business doesn’t have any better use for it. Typically, larger, more mature firms choose to do this. By contrast, younger companies tend to retain the capital and reinvest it in their future growth.
This means that every couple of months, I can receive money in my bank account without having to lift a finger. And as long as I keep holding the shares, the money will keep coming in. What’s more, if I choose to automatically reinvest any dividends received, the next dividend cheque gets that much bigger, unlocking the power of compounding.
That certainly sounds fantastic. However, it’s far from risk-free.
The risks of dividend investment strategies
As dividends usually come from mature, established businesses, a common misconception is that these stocks are low-risk. But remember, the capital used for payouts is taken from profits. That means, if profits start falling, dividends are more than likely to suffer as well, potentially jeopardising any passive income. Disruptive events can cause a problem too. In fact, this is precisely what happened in March 2020 at the start of the pandemic. Even the most mature companies were disrupted. And approximately £30bn worth of dividends was cut or outright cancelled in the UK alone, plus there were losses caused by falling share prices.
A good chunk of the healthier businesses have since recovered and reinstated their dividends. But many remain in a troubled state. For example, Carnival is one of the leading firms within the travel industry. It’s historically offered sizable dividends that evaporated last year as it came to the brink of bankruptcy.
The bottom line
2020 serves as an excellent example of what could go wrong. This is why most personal finance advisors say not to invest money that’s needed within the next five years, even in ‘low-risk’ dividend stocks.Â
While I certainly agree with this advice, 2020 was an exceptional year. And I still believe the passive income-generating potential of dividend stocks is worth the risks. Provided, of course, that the underlying business is fundamentally sound. And it needs competitive advantages that will enable it to sustain a high dividend yield for many years to come.