Passive income is one of the gateways to financial independence. Unlike capital gains from the sale of stock, where an investor must take an action to close a position in order to book the gains, passive income happens automatically. Examples include dividend stocks, interest from a bond or savings account, and income from a rental property.
It’s hard not to like the idea of making money by letting your hard-earned savings work in your favor. But there are many passive income pitfalls that investors make. Some of these can even lead to losses that exceed the gains made from passive income.
Here are three passive income pitfalls worth understanding and avoiding in your quest to find quality income stocks.
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1. Succumbing to the allure of a high yield
The dividend yield is a critical part of any income stock. But it can be misleading at face value.
Here’s a hypothetical example. Let’s take two stocks that are both $100 a share and pay a $0.50-per-share quarterly dividend, or $2 per share per year. At the current price, both stocks have a dividend yield of 2%.
After a period of five years, one stock does very well thanks to a strong underlying business. It has grown to a value of $200 a share and raised its quarterly dividend from $0.50 to $0.75, or $3 per year. The stock price has doubled in value, but its dividend yield is now just 1.5%, when it used to be 2% five years ago. However, the gains the stock has produced far exceed any small changes in its dividend — so investors surely don’t mind the lower yield.
Meanwhile, the second stock is losing market share, struggling to be profitable, faces slowing growth, and is taking on debt to run its business. Its stock price has fallen 75% down to $25 a share. But it still pays a $2-per-share dividend. Its dividend yield is now a mouthwatering 8%. But the quality of the business has deteriorated to the point where the company is likely to cut its dividend, support it with debt (which is unsustainable), or collapse further to the point where the capital losses exceed the dividend income.
The lesson here is that it’s better to go with the 1.5% dividend yield than the 8% dividend yield because the company that backs the lower yield is a better business than the one that backs the 8% dividend yield.
A red flag is when a stock has a very high dividend yield but has underperformed the broader market, especially a smaller company. That’s usually a sign that the dividend yield is unsustainable.
However, this isn’t to say that all high-yield dividend stocks are inherently bad. In fact ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) briefly had dividend yields close to or exceeding 8% in 2020 because their stock prices had fallen so far while the dividends had remained the same.
Both of those stocks have since more than tripled from their 2020 lows thanks to their diversified business models, relatively strong balance sheets, and soaring oil and gas prices.
The dream is to find a reliable stock with a high dividend yield. Unfortunately, a high dividend yield of 10% or more tends to be too good to be true.
2. Not investing for the business first and the dividend second
A dividend is only as good as the company that distributes it. Using our example of ExxonMobil and Chevron, if an investor well versed in the oil and gas industry did a deep dive into both companies, they would find that each company had cut spending significantly, leading up to the oil and gas crash of 2020. This meant that each company was leaner, and had lower operating costs, so the price of oil needed to break even is lower today than it was just five years ago. Therefore, both high-yield dividend stocks would have been reasonable buys.
Probably the biggest mistake passive income investors make is to prioritize a high yield over all else. The better choice is to find an excellent company with a track record for paying and raising its dividend and then see if the yield is good enough to consider buying the stock.
For example, Procter & Gamble (NYSE:PG) has a dividend yield of just 2.6%. But it has paid and raised its dividend for 66 consecutive years, is the leader in its industry, generates a ton of free cash flow, and buys back a lot of stock. In this vein its reliability makes up for a lower yield because an investor knows that a name-brand company like P&G is likely going to keep growing its earnings and dividend for decades to come.
3. Mismanaging expectations
Building a passive income portfolio can be exciting and financially freeing. But high-quality and relatively safe income stocks often underperform the S&P 500 over the long term. That said, they also tend to be less volatile than the broader market.
Stable dividend-paying companies often have low growth. So, when the economy is booming and the stock market is rising, low-growth sectors such as utilities or consumer staples usually underperform. However, during economic slowdowns, these same sectors benefit from consistent consumer demand that is less impacted by lower discretionary spending.
Align your personal preference with your investment style
As with all things related to investing, it’s important to understand the pros and cons before buying. With a passive income portfolio, the goal shouldn’t be to beat the market but rather supplement income in retirement or generate stable inflows to meet financial goals.
The benefits of a passive income portfolio may not suit the opportunity cost for investors with a higher risk tolerance. But for folks with a greater aversion to risk, a shorter time horizon, and who value consistency and stability over outsized gains, understanding and avoiding these three passive income pitfalls can be a useful exercise when building a passive income portfolio that’s right for you.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.