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 …….