Working towards a chunky passive income is the dream. I’d love nothing more than to simply invest my hard-earned cash into some high-quality stocks and live off the yearly dividends.
I also love to plan. Simple maths shows that discipline, smart decisions and a dash of luck could make my dream possible. But investing is a tricky game with plenty of pitfalls.
I made some big mistakes when I first started on this journey. Here are three things that are worth considering when creating passive income.
Future dividends
I like the idea of using dividend stocks to fund my future. That includes the likes of Lloyds (LSE: LLOY). It’s easy to extrapolate some rough numbers based on cash invested and the dividend yield available.
For instance, Lloyds currently pays out 5.1% per year. A £10,000 investment today should therefore generate £510 a year in dividends at the current yield. Reinvesting those dividends alongside some extra savings and the numbers can add up quickly.
But the problem with this is that the bank must have the future free cash flow available to pay its dividends. That means I could be caught short if my passive income plan relies entirely on the current payouts from a given stock like Lloyds.
It’s important to assess the company’s long-term future and profitability. An easy mistake to make, but one that can hugely impact my future income. Lloyds scores well on this point.
Beware the juicy yield
What about the other component in the dividend yield calculation, current share price? A stock could look like a fantastic choice due to a high yield but it’s actually driven by a sell-off. Lloyds shares have suffered from weak sentiment for years, and while they’re up almost 24% over six months they’re down nearly 13% in the last month.
While the company’s dividend payment may not be impacted, it usually signals that investors are worried about the current valuation versus future expected cash flows.
It’s easy to fall into this trap when just starting out. I used to look at the top dividend yields and assume they would accelerate my passive income. In my experience, it’s not that easy.
If I was starting out again, I’d be wary of those stocks with a super-high yield where there has been a recent share price drop.
Diversify, diversify, diversify
In addition to company-specific risks, I always consider the market.
We could see a large recession, geopolitical factors or things like inflation make investors nervous. There is always risk when investing, that’s a given. However, I would try to protect my future passive income from market volatility where I can.
The best way I can think of is through portfolio diversification. Relying on one or two stocks to fund my retirement is risky. However, investing across sectors, including more defensive industries, can help provide some long-term benefits.
Building income
These are just three big mistakes that I’ve made in the past. I continue to look for ways to improve my portfolio and set myself up for a happy retirement in the future.
There are always investment risks, but that’s part of the game. Detailed research, a clear plan, and a long-term mindset are just some of things I hope will help me achieve my passive income dreams.
This post was originally published on Motley Fool
