Want tons of passive income? Avoid these 3 (very) tempting mistakes

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Dividend stocks are just as likely as other stocks to underperform the market and do pretty much anything but what you want them to do – rise and pay. So if you want to create a healthy passive income stream, you’ll need to avoid making a few basic mistakes.

The catch is that some of the worst dividend investing mistakes are disguised as juicy opportunities. Let’s go over three of the most tempting and destructive weaknesses so you’ll be protected against them when determining which passive income stocks are worth your money.

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1. Seeking high dividend yields

The most common and tempting mistake investors make when building passive income through stocks is buying company stocks solely on the basis of their high dividend yield. The problem with this approach is that dividend yields rise when stock prices fall, and vice versa. Take a look at Takeda Pharmaceuticals (TAK -1.03%) over the past five years:

Chart showing Takeda's dividend yield rising and price falling since 2020.

TAKS given by Y-Charts

Investing in Takeda just because its dividend yield is much higher than the market average of around 1.3% means you are investing without worrying about why the market’s perception of a stock’s value might change. An unusually high dividend yield relative to a company’s normal range is often a sign that Something recently caused the market to sharply lower its expectations for the company’s future earnings.

In the case of Takeda, it could be a failed clinical trial, which implies that it will not be able to realize any of the expected income from the project. At other companies, it could be the result of a worse-than-expected earnings report. You can always choose to buy their stocks with sober knowledge of recent issues, but it’s a massive mistake to dive in on high yield alone without finding the warts first.

2. Ignoring Growth, Sustainability and Consistency of Dividends

Dividend yields can be misleading in more ways than one. GSK (GSK 1.77%) and Innovative industrial properties (IIPR -0.92%) are two very different companies that both have around 4.5% dividend yield right now. But it absolutely does not means investors will get similar dividend yields from both stocks, and that’s not even close. Expecting comparable returns over time due to yield is a huge mistake. Consider the following table:

Chart showing Innovative Industrial Properties' dividend rising and GSK's falling in 2022.

GSK dividend given by Y-Charts

As you can see, Innovative Industrial has increased its dividend significantly over the past three years, while paying out steadily every quarter. In contrast, GSK has increased and reduced its dividend quarter on quarter, and there is no clear upward trend. Some companies prefer to manage their dividends like GSK, because that leaves the door open to pay up and down with earnings, and there’s nothing wrong with doing it that way – it’s just a lot harder to plan your passive income strategy around their fluctuating cash flow.

Conversely, IIP’s perpetually growing dividend is a key part of the stock’s appeal to investors, making them much more attractive for passive income investing. But a commitment to continually increasing dividends introduces the risk that the increases will not be sustainable relative to a company’s distributable cash flow. Slow-growing businesses are at particularly high risk of being cut. And it also introduces a risk that if investors come to expect an ever-increasing dividend, news of a postponed or canceled hike may cause them to sell and drive stock prices down.

If you’ve run out of stock ideas that have a good track record to maintain and grow their payout, check out the Dividend Aristocrats, all of which are large, stable companies that have at least 25 consecutive years of upside.

3. Count on (or fully discount) windfall dividends

Sometimes companies like Costco (COST -1.85%) issue special dividends to return excess capital to their shareholders. Most recently, it paid a special dividend at the end of 2020 of $10 per share. This makes their dividend growth over time look like this:

Chart showing multiple peaks and falls in Costco's dividend since 2014.

COST Dividend given by Y-Charts

If you were considering buying Costco stock right after its special payout was issued, its dividend yield would seem unrealistic, and investing based on this incorrect perception would be a huge mistake. Additionally, investing with the expectation that the company will declare more special dividends on a regular schedule is also a mistake. The appeal of special dividends is that they are one-time events that are largely unpredictable. You cannot build a consistent estimate of your monthly or quarterly passive income that incorporates them.

At the same time, it is a mistake to entirely cancel the chance to get a special dividend when you evaluate which stocks to add to your income portfolio. Most companies that issue dividends don’t have a history of special dividends, but some do, like Costco. You may not be able to plan around when you will receive the income, but understanding that you may be exposed to additional upsides from time to time could help you choose between two good options.

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