One passive income strategy I use is investing in dividend shares. I like the fact that I really do not need to do any work to earn dividend income. I also like the fact that I can use this strategy with whatever funds I can afford – I do not need the sorts of large capital sums that some passive income ideas require.
Here are four key elements to the approach I take.
1. Focus on future profits, not current yield
The passive income I can earn from investing in a company depends on the dividends it will pay me in future. Over the long term, a company needs to make profits and have spare cash it can use to fund dividends.
Some investors fall into the trap of buying shares just because they have a high dividend yield. But instead of focussing on dividend yield, I first try to assess whether I think a company has a strong enough business that it can support future dividend payments.
2. Buy shares I understand
Some shares pay big dividends, but I do not buy them. Why? Because I do not understand the company’s business well enough to be confident in my judgment about its future business prospects.
That is why my passive income portfolio includes a lot of familiar names like Direct Line and Lloyds Bank. These are businesses I feel I can evaluate because I understand them.
3. Realistic expectations
The idea of earning money without working for it sounds good. But I think it is important to set realistic expectations about the sort of income I can earn.
Imagine I had a spare £1,000 and decided to invest it in dividend shares. If the average yield was around 4%, I would hopefully earn £40 a year in dividends. Having an extra £40 a year is a bit of extra pocket money, but it is not going to transform my finances.
Even if I invested £10,000 and earned passive income of £400 a year, although I may be able to fund a short holiday or some new clothes, I would not be slashing my working hours any time soon! I do think passive income can be a useful supplement to my earnings. But it is important to be realistic about what I can hope to earn based on how much I am able to invest.
4. Diversified choices
No matter how much I like one share, I always make sure my portfolio is diversified across a range of companies and industries.
For example, I own British American Tobacco and rival Imperial Brands. They both yield over 6%. But what happens if new rules lead to falling cigarette sales? The only thing going up in smoke at some point might be my dividend dreams. So I make sure that one sector, such as tobacco, only ever represents a limited part of my portfolio. Similarly, no matter how promising I think one business may be, I always make sure to own a variety of shares.