The dream is to work towards a decent passive income. I would love nothing more than to simply invest my hard-earned money in some quality stocks and live off the annual dividends.
I also love to plan. Simple math shows that discipline, smart decisions and a pinch of luck could make my dream come true. But investing is a tricky game with many pitfalls.
I made some big mistakes early on in this journey. Here are three things to keep in mind when creating passive income.
Future dividends
I like the idea of financing my future with dividend stocks. These include, for example, Lloyds (LSE:LLOY). It is easy to extrapolate some rough numbers based on the cash invested and the available dividend yield.
For example, Lloyds currently pays out 5.1% per year, so a £10,000 investment today should pay out £510 per year in dividends at the current yield. If you reinvest those dividends along with some extra savings, the numbers can add up quickly.
The problem with this, however, is that the bank needs to have future free cash flow available to pay its dividends, meaning I could potentially be in trouble if my passive income plan is entirely dependent on the current distributions of a particular stock like Lloyds.
It is important to assess the long-term future and profitability of the company. This is an easy mistake to make, but it can have a huge impact on my future income. Lloyds scores highly on this point.
Beware of the juicy returns
And what about the other component in calculating dividend yield, the current share price? A stock might look like a fantastic pick due to a high yield, but in reality it’s driven by a sell-off. Lloyds shares have suffered from weak sentiment for years, and although they’re up almost 24% in six months, they’re down almost 13% in the last month.
While this may not affect the company’s dividend payout, it is usually a sign that investors are concerned about the current valuation compared to expected future cash flows.
It’s easy to fall into this trap when you’re first starting out. I used to look at the highest dividend yields and assume they would increase my passive income. In my experience, it’s not that easy.
If I were to start over, I would be cautious about extremely high yielding stocks that have recently fallen in price.
Diversify, diversify, diversify
In addition to the company-specific risks, I always also take the market situation into account.
There could be a major recession, geopolitical factors or things like inflation could make investors nervous. There is always risk in investing, that’s for sure. However, I would try to protect my future passive income from market volatility as best I can.
The best way I can think of is to diversify the portfolio. Relying on one or two stocks to fund my retirement is risky, but investing in different sectors, including more defensive ones, can provide some long-term benefits.
Build income
These are just three big mistakes I’ve made in the past. I continue to look for ways to improve my portfolio and ensure 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 the things I hope will help me achieve my passive income dreams.
The post 3 HUGE mistakes I made when I started building passive income appeared first on The Motley Fool UK.
Further reading
Ken Hall does not own any of the stocks mentioned. The Motley Fool UK has recommended Lloyds Banking Group Plc. The views expressed on companies mentioned in this article are those of the author and may therefore 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 2024
