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3 costly passive income mistakes to avoid

Various denominations of notes in a pile

Passive income can be appealing. Investing in dividend shares is one of the favourite passive income ideas of a number of people, including myself. But while investing in dividend shares has appeal, it can also involve risks.

I think being aware of some of the risks can help me avoid them and hopefully increase my potential income. Here are three common mistakes I’d seek to avoid.

Mistake 1: over-emphasising historical dividend data

How can one tell what the dividend yield of a given share may be?

The most common method is to look at the most recent dividend, as a percentage of the current share price. That makes sense as it’s the most up-to-date information available. But it’s backward-looking. If I am considering buying a share I am interested in what it might pay me in future, not what it paid out in the past.

I do think historical dividend data can help me in some ways. It helps to show how a company feels about the importance of dividends, for one thing. For example, last year when the outlook was uncertain, Legal & General maintained its dividend while rivals such as Aviva suspended theirs. That can be helpful in managing my own expectations about a company’s willingness to axe its dividend.

The dividend history can also give me some insight on what the dividend will be like if it is maintained at a similar level to before.

But while such information can be informative, it doesn’t give me clear guidance on what the company’s future dividends will be. For that I need to make some judgments of my own based on the available information. For example, I can look at a company’s accounts and see how much free cash flow it has been generating. I can then consider whether I expect it to be able to maintain its free cash flow generation at that level in years to come. To do that I’d consider a variety of questions. Is customer demand likely to grow or shrink? Does the company have pricing power to enable it to maintain its profit margins? Will it need to increase its capital expenditure in coming years, perhaps because it needs to modernise its factories or invest heavily in some new technology?

So while I do pay attention to historical dividend data, I don’t think it’s the most important thing to look at when deciding whether to add a share to my portfolio for its passive income potential. Instead, the key aspect of my analysis is what the dividend might look like in future.

Mistake 2: buying an attractive dividend at an unattractive price

Which of these two dividends sounds more attractive? £2.08 a year or £1.54 a year?

If you’ve answered that question already, you may have done so too fast. A dividend amount in isolation doesn’t help me know whether a share might be a lucrative passive income pick for my holdings. Instead, what I need to know is a share’s dividend yield. That is a function of the dividend but also of the price at which I buy the share. So, for example, if I buy a share at £20, an annual dividend of £2.08 would mean that I got a yield of 10.4%. But if the same share moved up to £35, and I bought it at that price, my dividend yield would only be 5.9%.

This matters a lot for passive income. The price at which I buy the shares today will affect the yield I get for as long as I hold them. If I have £1,000 in dividend shares and the average yield is 3%, I would get £30 of passive income in a year. But if I put the same £1,000 into the same shares at a different price, my passive income might look very different. If I bought the shares when they were 50% cheaper, my passive income would be £60. If I purchased them when they were 50% more expensive, my passive income would be £20.

Such swings in price over the course of several years aren’t exceptional. Consider as an example the popular dividend share BP. This year alone it has traded as low as £2.51 but also as high as £5.08, more than double its low. Buying at the lower price, I would now be getting slightly over double the yield I would have received if I bought at the higher price.

So I think it’s a mistake to look just at the absolute size of a dividend when I am hunting for passive income ideas. Instead, I also need to consider the share price at my time of purchase.

Mistake 3: ignoring share price falls

Another mistake I try to avoid when looking at passive income ideas for my portfolio is neglecting the threat of long-term share price decline. Let’s say a share offers me a high yield, but meanwhile its share price declines markedly over the course of years. Am I just receiving with one hand what is being taken away with the other?

The answer to that depends on the exact circumstances. If I continue to hold the shares and the share price decline is just because a company has fallen out of favour with investors, it might not matter for me. I could still receive my passive income — and the share price may have recovered by the time I come to sell the shares years down the line.

But it is a different situation if the share price decline reflects a worsening business. That could mean that I am unable to recoup my original investment if I decide to sell the shares in future. On top of that, the worsening business could mean dividends are cut at some stage. Even with an attractive initial yield, if the share price falls far enough, I may still lose money over time.

So when choosing passive income shares for my portfolio, I try to assess whether the share price looks overvalued. If it does, I would be wary of buying the shares no matter how high the yield might be.

The post 3 costly passive income mistakes to avoid appeared first on The Motley Fool UK.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.