Published on January 2nd, 2018
This is a guest contribution by Joseph Hogue. Joseph Hogue worked as an equity analyst and an economist before realizing being rich is no substitute for being happy. He now runs five websites including an investing blog, makes more money than he ever did at a 9-to-5 job and loves building his work from home business.
Dividend investing can be a solid source of passive income but look to diversify with other sources
Dividend investing can be a great long-term wealth builder but how good is it as a source of passive income? Can you depend on your dividend payments or returns to provide continuous and consistent income when you need it?
Dividends from blue-chip companies can be extremely reliable but depending on them as a source of income could leave you scrambling for cash.
Besides the threat of a bear market, dividend investing is only as passive as you make it. Many investors set out for a buy-and-hold strategy and then get trapped with a full-time burden of analyzing and trading stocks.
So how do you make dividend investing as passive as possible and are there ways to diversify your passive income sources?
How to Make Dividend Investing a Passive Income Source
Investing can be one of the most passive income sources you’ll find or it can be a full-time job if you let it. Working as an equity analyst for institutional firms, I knew portfolio managers and wealthy investors that traded stocks on a daily basis. Even some that claimed to be long-term investors would buy shares and then change their mind on the position within a few months.
I’m not saying that stock analysis and active management doesn’t produce returns, that’s an argument for another post, but it certainly doesn’t make for a passive income source.
To make dividend investing truly passive, you have to let some of the analysis go. You might look for good stocks to buy for long-term investments but after that, your holding period needs to be decades.
But where do you draw the line between trying to make dividend investing as passive as possible and still making rational decisions on your investments?
Do you rebalance your portfolio after stocks have made a strong run through a bull market? Do you set criteria for when to sell a stock after it has disappointed?
For example, General Electric (GE) has been the bedrock of many dividend portfolios for decades. In the three decades to 2017, shares produced an annualized 10.5% return with 3% of that in dividends. Shares sank by nearly half in 2017 and wiped out nearly five years’ worth of returns.
I like to make my dividend investments as passive as possible, but I’m not going to wait for a stock to halve before I make the active decision to cut it from my portfolio.
To minimize the time I spend actively following my stocks, I’ve set criteria for when I need to buy or sell within the portfolio. This helps to keep the investments as passive as possible but lets me guide the portfolio when I should.
- I use a mix of calendar- and percentage-rebalancing rules. I rebalance back to my asset allocation targets, i.e. how much in stocks versus bonds, every five years. I also rebalance if either asset class is more than 15% outside the target percentage of my total portfolio.
- In an annual check on the portfolio, I make the hold-sell decision on any stock that has underperformed its sector returns by more than 20% over the year.
- A big part of my sell decision if a company has underperformed its sector depends on its debt leverage. Companies can recover from a down-year but only if they have the financial flexibility to do so. A company with too much debt can quickly find itself in a downward spiral of interest payments and credit downgrades.
- I sell any stock where management has been accused of misleading investors or has committed a fairly large mistake that will have legal consequences. Management can make mistakes but I’ve found that large legal problems can weigh on a company for a very long time.
These are by no means infallible criteria but I’ve found they strike the right balance between letting my portfolio run its course and still giving me some active control.
The biggest lesson I’ve learned in passive investing is not how to make one particular investment passive but to build a passive portfolio in several types of investments.
How Do Dividend Stocks Compare on a Passive Income Scale?
While dividend stocks are among the most passive investments I’ve found in more than two decades of investing, they aren’t the most passive. They also aren’t the only investment you should make if you want to create a truly passive income.
I found out the hard way that real estate investing isn’t as passive as some would have you believe. The 3am infomercials and get-rich real estate books make it seem like all you need worry about is financing a portfolio of rental properties and letting your tenants pay the mortgages.
In fact, direct real estate ownership requires constant management of tenants, finances and properties. There are management companies that can take some of the burden off your shoulders but it can be difficult finding a company that will manage a small portfolio of a few single-family rentals. Management costs will eat into your cash flow and may not be feasible for investors just starting out.
Real estate investing can be much more passive if done by owning real estate investment trusts (REITs) which trade like stocks. REITs give you professional management of a large portfolio of properties, usually in one property type diversified across markets. With REITs, you no longer have the active management decisions on properties though you may still have to make active decisions on the shares.
Bond investing may be the most passive form of investment you’ll ever find. Sure, you can do just as much analysis and trading in bonds as you can in stocks but because of the fixed payments and contractual-nature of the investment, I’ve found most investors worry a lot less about their fixed-income portfolio.
Bonds provide a fixed payment to the maturity of the debt then pay the face value of the bond. Since the return to maturity is known at the time you buy the bond, there’s little need to follow the company’s progress unless default becomes a possibility. Buy solid, investment-grade bonds and the only decision you’ll need to make is how to reinvest the money every decade or so.
Related to bond investing and just as passive is peer-to-peer lending investment. P2P investing on sites like Lending Club is just like bond investing though it’s in personal loans rather than corporate debt. Loans are for shorter-durations from three to five years but most platforms have an automated investment system where you set the criteria for your investments and free cash is invested each month.
There is one source of semi-passive income I think competes well with stocks, bonds and real estate. I’ve published 10 books on Amazon and found self-publishing to be extremely passive. It obviously takes more to develop and publish a book than it does to buy a stock but once a book is published, there is very little to do on a continuous basis.
I spend approximately $200 a month in advertising on Amazon and make nearly ten-times that in sales. The advertising is all continuous so there’s no active management required. Self-publishing isn’t for everyone but is definitely something you should look into if you’re looking for passive income sources.
Having passive income sources across a range of assets means I worry less when one source falls on hard times. While dividend investing can be a great source of passive income for the buy-and-hold investor, the income can be volatile during bear markets. Diversify your passive income with investments in REITs, bonds and even in sources like self-publishing.