Creating a passive income is one of the best things you can do for your long term finances. Passive income helps you absorb sudden life changes, and help you pursue your passions and dreams.
One of the most reliable truly passive income streams can be from a group of solid dividend paying companies. Dividends are regular cash payments that a company will make to investors just for holding shares of the company’s stock. The dividends are paid on a per share basis, so the more shares of the company’s stock you hold, the larger your dividend.
Sounds good so far? Not all dividends are created equal, though. Some companies pay dividends, some don’t, and those that do have payout rates all over the place ranging anywhere from 0% to 20% (and higher).
Since companies aren’t required to pay a dividend, those that do can cancel their dividend at any time. Typically, a company won’t do this at a drop of a hat, but if their profits start drying up, the dividend is going to hit the chopping block. The last thing you want is to invest a bunch of your money in a company, just to find yourself a year later with worthless stock and no dividend. And don’t think that building a good dividend stream is as easy as picking stocks with high dividend payouts. In fact, this is a quick way to lose all your money. Often a high dividend yield simply means that investors are dumping the stock and the stock price has dropped. This is usually because the company is in trouble and a drop dividend price is likely imminent.
So to create a reliable income stream, you need to make sure you are investing in companies that are likely to continue making profits indefinitely. For the most part, these are big companies that you probably recognize- Johnson and Johnson, 3M, Walmart, etc. When you’re investing specifically for the passive income, you want to look at the company’s history of profit, and their history of dividend payouts. Even big companies occasionally stumble however (look up Kodak), so you do want to spread your investment out among several companies to minimize your risk.
Passive Income From Index Funds
You could do all the research and legwork of investing in several companies yourself. You can pore over income statements and dividend history reports on sites like Google Finance and Dividend.com. Fortunately, mutual fund companies have got you covered. Several funds specifically invest in companies that have a history of solid dividends. To maximize return, pick an index fund with a low expense ratio from somewhere like Vanguard. My personal favorite is Vanguard’s High Dividend Yield Index Fund because it combines the stock market’s faster growth with dependable income from dividend stocks. If you’re wanting a higher payout right away without as much future growth, Vanguards’ Long Term Corporate Bond Fund might be a good choice.
Ignoring the Underlying Value
Since these funds are investing in the stock market, the value of your investment is going to rise and fall significantly. For more on the risks and rewards of investing in the stock market, see this post. Butf you’re strictly investing for the passive income, the volatility in the stock market isn’t really an issue, since steady dividend companies maintain their payouts through thick and thin. However, if you may need the funds that you’re investing in the near to medium future, you’d be better off in a bond fund. Bonds don’t typically offer as good of a long term return as stocks, but they maintain a much more stable cash value.
Picking A Fund That’s Right For You
When you’re looking around at funds, you’ll notice several statistics and numbers. There are a few that you should pay close attention to. The expense ratio is how much the mutual fund takes from your total investment each year. This covers the cost of doing business. Stick to funds with lower expense ratios- several are less than a third of a percent. The dividend yield is similar to the interest rate on your bank account. This is a percent based on total current investment value that you will be paid each year, assuming the dividend stays the same. Although the dividend won’t actually stay the same, with a good fund, it should actually rise over time. Look for funds with yields of at least 2%, or slightly lower if you’re looking for a very stable bond fund.
Once you’ve selected a fund, setting up your income stream is as easy as setting up an account with the fund company and buying your investment. If you want access to your income stream prior to age 60, you’ll need to set up a regular account. Otherwise, you can set up a retirement account to make your investment more tax efficient. Once your account is set up, you can decide whether you want your dividends re-invested or deposited in your account. If you’re just setting up this investment stream for the future- for early retirement or to help in a job loss for example, you can opt for dividend re-investment now, and then change your selection when you want to start collecting your dividend. This way your dividends help grow your investment, which also grows your future dividends.
Slow and Steady Growth
As I’ve said in my past posts about passive income, building passive income often takes up-front sacrifice. Nothing you read on Pennies and Dollars is a get-rich-quick scheme. Investing in dividend paying companies is no different. For example, if you’re aiming for a passive income of $1,000 a year, you’d need to invest in the neighborhood of $30,000 (assuming a 3.3% dividend yield). You likely aren’t going to be able to build a $1,000 dollar income stream overnight, much less a $20,000 one. Like I said, not a get-rich-quick scheme. You’re best bet to achieve any kind of significant passive income by investing is by recurring investment. Set up an automatic monthly investment of $50, $100 or whatever you can afford, and your income stream can grow.
Before you get discouraged by the up-front investment costs, consider a few things. A passive income stream can be one piece in your personal safety net that protects you from unexpected expenses or other life changes. If you’re not comfortable devoting a monthly investment to only developing an income stream, you can pick a more stable bond fund, using the fund to both generate income and act as an emergency fund. And before you say you don’t need a $30,000 emergency fund, remember that most financial experts advise stashing away enough to cover 3-12 months worth of expenses. Rather than having this stash collecting a paltry .5% in the bank, you might as well let it generate a bigger income in a stable bond fund. That way, if you’re fortunate not to ever need it, it will have been working for you all along.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.