As a passive income source, I find it hard to beat dividend stocks. Buying shares, then sitting back and waiting for dividend income truly is passive. But with hundreds of UK dividend shares to pick from, it can be confusing to know where to begin. Here’s how I’d start investing in UK dividend stocks from scratch.
Focus on objectives
First I’d think about why I wanted to invest in dividend stocks particular. Broadly speaking, there are two main types of shares from an investing perspective: growth shares and income shares. There is no hard and fast dividing line. But at a basic level, growth shares are companies operating in a large untapped market that could allow them to grow their future sales and profits quickly. Rather than pay out cash they generate as dividends, such companies tend to reinvest it in growing the business. Consider Tesla and Amazon as examples.
By contrast, income shares pay out dividends to shareholders. Often that is because growth opportunities in their industries are limited. But it can also be a conscious choice, to help make the shares more attractive to investors. Examples include British American Tobacco and Tesco.
Dividend stocks are some of my favourite passive income sources. If I didn’t want passive income, I would still buy some dividend stocks but likely I’d orient my portfolio more towards growth shares. So, before investing any money in dividend stocks, I would clarify in my own mind what my investment objectives were.
Researching dividend stocks
Next I would learn more about possible dividend stocks that could meet my own investment objectives. This is where I think many new investors go badly wrong. They focus on a company with an unusually high yield, not realising that it reflects a one-off special dividend, or that the business is already in decline, or that the company is in a cyclical industry, which means dividends could soon plummet, for example.
These lessons are hard learnt, but starting out I’d ask myself: how likely am I to outperform the investor community as a whole? In reality, an unusually high dividend is often a signal that far more successful investors than me have seen a challenge for a company’s future payout levels, and are marking down the share price accordingly. As a private investor I’ll never have the resources of a professional investment team behind me. But I can read widely, research carefully and focus not only on the dividend level, but also on how sustainable a company’s dividend looks to me.
Investing in a diversified portfolio
Now I’d be ready to start buying dividend stocks. A monthly saving habit can help discipline me to build up my investment pot. Rather than focus on just a couple of companies, no matter how good I thought their dividend prospects were, I’d seek to reduce my risk by diversifying across a variety of companies and business sectors. Dividends are never guaranteed and even the best of companies can unexpectedly run into hard times.
With all that done, I’d sit back and wait for my passive income streams to hopefully grow over time.
Christopher Ruane owns shares in British American Tobacco. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK owns shares of and has recommended Amazon and Tesla. The Motley Fool UK has recommended British American Tobacco and Tesco and has recommended the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. 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.