‘Generate income without a paycheck’: How dividend investing can make you money while you sleep – CNBC

Financial sites across internet will tell you how you can earn passive income, but let’s be honest — a lot of what’s touted as passive income isn’t actually passive.

Take real estate investing. Once you buy a rental property, the thinking goes, your renters cover your mortgage and then some. Every time you hike the rent, that’s more profit in your pocket. Any honest real estate investor will tell you, however, that being a landlord is work — oftentimes quite a lot of it.

If you want to generate income that’s truly passive, consider dividend investing. While relying on cash payouts from a stock portfolio is a common strategy for those nearing and in retirement, anyone can build an equity income portfolio, says Brian Bollinger, president of Simply Safe Dividends.

The goal for many users of his site, old and young, says Bollinger: “Generate income without a paycheck.”

Here’s the general gist. You invest in companies that regularly distribute a certain amount of money to their shareholders. If all goes well, you collect a growing pile cash each year while the stocks you own appreciate in value.

How dividend investing provides income

A quick refresher on how dividends work: Companies that earn excess profit can choose to return some of that money to their shareholders, as a sort of thank you, in the form of a regular cash payout. Some investors use these dividends as a form of income. Other, usually longer-term investors like to take those dividend payments and reinvest them, thereby boosting the return they earn on the stock.

For both types of investors, determining the attractiveness of a dividend comes down to the stock’s yield, found by dividing the amount of money an investor receives from a single share into the stock’s share price. If one share of stock costs $100 and comes with a $1 annual payout (a common configuration might be quarterly payments of 25 cents), its dividend yield is 1%.

Stocks in the S&P 500 index currently yield about 1.5% on aggregate. That means, if you have $1 million invested in a mutual fund or exchange-traded fund that tracks the index, you could expect annual dividend income of about $15,000.

Dividend income strategies to consider

Whether you’re choosing your own dividend stocks or investing through a mutual fund or ETF, you’d generally be wise to follow one of these two dividend strategies that aligns with your particular needs, experts say.

1. Higher yield

Investors looking to maximize their income may target stocks or funds that pay a high yield.

While the income such stocks offer can look juicy — individual stocks in the S&P 500 currently yield as high as 9.7% — you don’t have to think too hard about the calculation above to see why some yields are higher than others. The more a stock falls in price, the higher its yield climbs.

Companies that are in trouble not only provide shaky returns, but may be forced to cut the dividend as a result of poor financial results.

“Stuff that’s over 5% or 6% probably isn’t a good idea if you’re a risk-averse investor,” says Bollinger. “Even if the dividend does end up staying stable, it’s pretty unlikely to grow.”

One way to defray some of the risk is to invest in a broad basket of dividend stocks, says Todd Rosenbluth, head of research at VettaFi. “The benefits of diversification become really important,” he says. “Owning dividend stocks in an ETF can make a lot of sense for equity income-oriented investors.”

2. Dividend growth

Some dividend investors are happy to take a lower yield — maybe even not much higher than the S&P 500’s — to invest in companies that steadily grow their payout.

“I generally like to advocate for an approach of targeting great businesses that might pay closer to a 3% to 4% dividend yield,” says Bollinger. Such companies often steadily grow their payout, which boosts your annual income stream — a move that helps offset the effects of inflation, he says.

Among companies with smaller yields, “you’re usually looking at safer companies with safer payouts as well,” Bollinger says.

Not all stocks that yield in this range will grow their payout, and pros like Bollinger have created tools to help determine the whether a company is likely to, taking into account fundamental factors such as earnings growth, debt and trajectory of cash flows.

Short of that, many investors seeking steady dividend growth look to the past, relying on companies with a long history of dividend growth. The S&P Dividend Aristocrats index for instance, includes companies in the broader index that have hiked their dividend for at least 25 consecutive years. Stocks in the index currently yield 2.5%.

Many of these firms are established, financially mature companies, says Bollinger. Building a diversified portfolio of them, he says, can give you peace of mind that you’re building an underlying portfolio that will continue to grow alongside an expanding pile of passive income — regardless of swings in the market.

“When stock prices fall, it’s so easy to panic, but dividend investing can overcome that because you’re just trying to stay focused on your income stream,” says Bollinger. “You don’t care so much about the markets’ short-term ups and downs anymore.”

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