Passive income is money earned without work. Someone who knows all about that is legendary investor Warren Buffett. His company Berkshire Hathaway owns a portfolio of shares that generates millions of dollars in passive income each week.
While my ambition is far more modest than that, I think it makes sense to apply the wisdom of a successful investor like Buffett when trying to boost my own passive income streams.
Here is how I would use his approach when selecting shares for my own share portfolio.
Focus on where the ball is going
If dividend shares are an important source of passive income, the higher the yield on those shares the more money I would hope to earn.
Although that is true, it leads some investors to fall into a trap. A value trap, sometimes known as a yield trap, is what happens if I buy a share because of its high yield only to discover down the road that the dividend gets cut, or axed altogether. Not only is my passive income reduced, the share price could also fall as investors adjust to the new reality.
One way Buffett tries to avoid yield traps is by looking forwards not backwards. He does not focus exclusively on a share’s dividend history. Instead, he considers the share as a small stake in a business. So he assesses whether the business has the ability to make large profits in future that could fund dividends.
Go for quality
There are lots of good businesses around. But there are few truly great ones. I reckon Buffett has some of them in his portfolio – companies such as Apple, American Express and Coca-Cola. What I think makes these three businesses great, in my opinion, is they each have something no competitor can copy directly, whether it is an iconic brand or loyal customer base.
That matters from a passive income perspective because it gives those companies pricing power. In other words, because they have a unique offer, customers will be willing to pay a price premium for it.
That can help support profits – and dividends. Apple pays a dividend. American Express pays a dividend and last reduced its payout in 1994. Coca-Cola pays a dividend and has increased it for 60 years in a row.
By identifying quality businesses with a sustainable competitive advantages the way Buffett does, I can invest in businesses I think can make profits to fund dividends far into the future. Over time, that should help my dividend income streams significantly. Hopefully, I could earn passive income for life.
Passive income is linked to share price
But while Buffett likes great companies, so do other investors. That can push the prices up to silly levels. Quality shares are often not on sale, but sometimes they are. Like Buffett, I use those moments as buying opportunities to boost my passive income streams.
Buffett typically only buys shares when they are attractively priced. Doing that matters a lot to my passive income streams, as if I buy a share when its price is low I will get a higher dividend yield than buying the same share when its price is higher.
I am always looking out for great companies, even if their current price means I will not buy their shares just yet.
