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How I’d invest in dividend stocks to generate passive income

Close-up of British bank notes

A main objective of mine is to grow my passive income stream. I think dividend stocks are a great way to do this because the income I receive is truly passive. It requires little effort from me after I buy the shares, as long as I monitor how the businesses are performing.

It’s important for me to pick the right dividend stocks for my portfolio so my passive income stream is reliable. With this in mind, here’s how I select dividend stocks to grow my passive income.

Stocks with high yields

The first thing I look for when selecting dividend stocks is the yield. This determines how much I need to invest when I buy shares in order to earn some passive income. Therefore, the higher the dividend yield, the more income I will earn from my portfolio.

The UK market is a great place to search for stocks with high dividend yields. The FTSE 100 index has generated a 12-month dividend yield of 3.7%. I could buy the iShares Core FTSE 100 ETF (LSE: ISF) — or a variety of other Footsie trackers — to gain exposure to this large-cap index, which would mean I’d be diversified across 100 stocks.

There are many companies in the UK with higher dividend yields though, so I can aim higher than 3.7%.

Rio Tinto and BHP are mining companies that boast dividend yields far higher than the FTSE 100 index. Rio Tinto in particular has a forecast yield in the double-digits right now. I also like the look of insurance groups Direct Line and Admiral, two companies with dividend yields over 8%. Legal & General is another insurance company but with an asset management business too. It has a current forecast dividend yield of 6.2%, which is attractive for my portfolio.

Growing my passive income

It’s not all about high dividend yields though. Yields can be high for a number of reasons, but they can often be ‘too high’ after the share price of a company has fallen in anticipation of a potential dividend cut. This happens when the underlying business is struggling and profits have fallen. So I always dig a bit deeper to see if the high dividend is likely to be paid in the future.

One way I do this is by looking at dividend growth forecasts. Sometimes it’s better to buy shares of a company that’s rapidly growing its dividend payments, rather than looking for the highest yield today. I invest for the long term, so a company that has many years of growth ahead is favourable for my portfolio.

Royal Mail is a company with a huge expected growth rate in its dividend payment. The company has performed well recently, which has meant it can up its dividend. The forward dividend yield is now a respectable 4.7%. Liontrust Asset Management is another growth share that’s planning on increasing its dividend payment (by an impressive 38%). This would mean the yield is 3.1%, and up from the current 2.2%.

I always build my portfolio with a mix of high dividend yields and companies that are growing their dividend payments. This helps to diversify my investments, as there’s always a risk of dividends being cut, or worse, stopped altogether. However, I still view dividend stocks as a great way to generate passive income.

The post How I’d invest in dividend stocks to generate passive income appeared first on The Motley Fool UK.

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Dan Appleby owns shares of Rio Tinto, BHP and Legal & General. The Motley Fool UK has recommended Admiral Group. 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.