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While there are lots of ways of earning passive income, most take a lot of cash or some specialist skills to get off the ground. Investing in the stock market, however, requires none of these.
There are some things to be careful of and rules investors — especially beginners — should try to stick to. But shares in companies that distribute part of their profits as dividends can be a great source of passive income.
Time
Whether it’s building wealth or earning passive income, one of the most important rules for investing is to be patient. Warren Buffett – one of the best investors of all time – puts it like this:
“No matter how great the talent or the efforts, some things just take time – you can’t produce a baby in a month by getting nine women pregnant.”
He’s right – not just about the biology, but about the stock market as well. Sometimes, what look like opportunities to fast-track returns present themselves, but these are usually traps.
With dividend stocks, this shows up most often with dividend yields. These can be very high – and very attractive – but they don’t always offer the kind of returns investors might hope for.
High yields
Taylor Wimpey (LSE:TW) is a good example. The stock currently has an 8.8% dividend yield and compounding £100 a month at that rate of return leads to something generating £1,485 in year 10.
That sounds terrific, but there is a catch. The FTSE 250 housebuilder’s dividends have been higher than its net income in recent years – in other words, it’s paying out more than it’s taking in.
As a result, the book value of the company has gone down and the stock has fallen in a way that reflects this. So investors who bought the stock five years ago haven’t earned a good return at all.
This isn’t to say Taylor Wimpey will be a bad investment going forward – the UK’s housing shortage should help with long-term demand. But investors shouldn’t be lured in by a high dividend yield.
Starting small
It sounds paradoxical, but lower yields can sometimes create higher returns. Diploma (LSE:DPLM) has never been a big dividend stock, but investors haven’t had much to complain about.
A 1.15% dividend yield doesn’t exactly jump out, but this is only part of the story. The industrial distributor keeps and reinvests the majority of its earnings to generate higher future profits.
A strategy focused on acquiring smaller operations always brings a risk of overpaying. But the firm has a very successful track record, especially under its current management team.
As a result, the dividend has more than doubled in the last five years. And if this carries on, income investors could well find themselves rewarded with growing future returns for a long time.
Patience and time
I think the stock market is one of the best places for passive income investors to look for potential opportunities. But there really is no substitute for patience and time.
A high dividend yield can feel good at first, but this isn’t much good if it all goes wrong later. A lot of the time, starting small, and being patient can be the way to get the best results.
