Generating a steady stream of reliable passive income is arguably one of the most popular financial goals. The ability to see money magically appear in the bank without having to lift a finger may sound too good to be true. Yet millions already enjoy this benefit in the form of dividends from an investment portfolio.
With that in mind, let’s go through the five main steps to building a diversified passive income portfolio.
1. Raise capital
As with any financial venture, the first step is to raise some cash. After all, shares aren’t free, and investors need money to make money.
Finding capital for investments can be tough. This cash will likely be invested for several years. And while it’s always possible to pull money out early, this can significantly harm a portfolio’s performance.
The good news is with some trading fees and commissions dropping to near-free, investors don’t actually need much to get going. And setting aside as little as a few pounds a day is enough to start accumulating a decent lump sum to invest in dividend shares.
2. Learn about dividends
For a passive income portfolio, the most likely strategy is to focus on dividend stocks. However, just because a company offers a high payout today doesn’t mean it will stay that way.
Unlikely the interest income from bonds, dividends are not mandatory for companies to pay. They exist purely as a mechanism to return excess capital back to the owners of the business (the shareholders).
However, if there are no excess earnings, then dividends are likely to be cut, suspended, or even outright cancelled. And suddenly, a promising source of passive income runs dry, with the share price usually dropping sharply thereafter.
3. Find passive income opportunities
Investors need to investigate a company’s free cash flow generation capabilities to see whether dividends are sustainable, or heading for the chopping block.
There are obviously plenty of other factors that go into making an investment decision. But by filtering out companies with tight margins, the search for lucrative passive income opportunities can be greatly narrowed.
It’s also worth investigating a firm’s track record. Suppose management has been able to consistently raise shareholder payouts with organic cash flow for years, or even decades, then investors could be looking at a reliable and expanding source of dividend income.
4. Invest
After isolating the most promising passive income stocks, it’s time to start putting capital to work. Investors should strive to build a dividend portfolio containing a variety of companies operating in different industries. This is called diversification, and it can significantly reduce risk exposure.
There is a lot of debate, but the ideal number of stocks to own usually lies between 15 and 25. However, be aware that owning too many stocks can dilute investment returns. So investors need to find the balance between risk and reward that works for them.
5. Earn passive income
With a portfolio in place, there’s not much else to do but hopefully watch the money roll in. If I aim for £1,000 a month at an average 5% yield (which, of course, isn’t guaranteed), I’ll need a portfolio worth £240,000. Obviously, that’s not pocket change.
But steadily investing capital each month, reinvesting any dividends received, and hitting this milestone, long term it’s truly possible.
