3 passive-income stock secrets you'll wish you knew earlier

You'll have more success with dividend investing with the right approach.

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This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Building up a quarterly stream of passive income through shares of dividend-paying stocks is a dream for many investors, but a lot of people approach it the wrong way. You can't expect to build up a huge amount of passive revenue overnight, and you'll need to have the right strategy to accumulate shares of dividend stocks that will be stable in the long-term.

Let's examine three passive-income secrets to bolster your dividend flows and ensure that they aren't eroded.

1. You don't have to receive your dividends now

The most important passive-income secret is that you don't need to actually accept any dividends in the form of cash if you'd prefer to make a larger amount of cash down the line. By setting up a dividend reinvestment plan (DRP), you can keep adding to your position automatically quarter after quarter, meaning that you'll have more shares producing dividend income than you would if you had spent the money rather than reinvesting it.

Let's work through an example with the pharmaceutical company AbbVie Inc. (NYSE: ABBV) to see how dividend reinvestment can boost your returns. Over the past five years, AbbVie has achieved a total return of 96.5%; however, the price of its shares alone only gained a bit more than 61%. In the same period, the company hiked its dividend by 120%, thanks to profitable sales of its ever-increasing portfolio of medicines.

If you're not familiar, the total return of a stock accounts for the impact of dividend payments as well as share price appreciation, so it's a good proxy for how much you'd make if you were reinvesting rather than spending the cash. Therefore, if you simply accept the company's payments and spend them, you'll have significantly less than if you set up a DRIP and wait the equivalent amount of time.

So when you're thinking about passive income, it makes sense to think about when you will want to spend the money. The longer you can defer spending and keep reinvesting, the larger your income will ultimately be.

2. You don't need to worry about beating the market 

But as a passive-income investor, outperformance shouldn't be your goal, nor should it be something you expect to achieve most of the time. The reason: You're invested for the cash flow, not the stock price returns. As long as the cash flow keeps rolling in at the same rate, the rest doesn't matter so much.

Everyone talks about outperforming the market with their portfolio, and much ink is spilled about which stocks are likely to grow faster than the market's long-term average of around 10% annually.

The type of companies that have highly stable cash flows to make long-term passive income tend to be more interested in returning capital to shareholders than other companies that are more focused on deploying capital to grow. Take Innovative Industrial Properties (NYSE: IIPR), a real estate investment trust (REIT), as an example. Its business model is to buy marijuana cultivation facilities, then rent them back to their former owners to capture a long trail of income. 

The company has underperformed the market over the last three years, but its dividend has risen by 124% in that time. Right now, its forward dividend yield is near 7.7%, which is quite high.

If you plan to invest in Innovative Industrial Properties expecting a certain amount in cash annually based on your initial purchase, its performance relative to the market is a moot point. You'll get your cash flow regardless of what the market does, as long as the business can support the payout. 

3. Diversify your holdings to avoid wipeouts

A third secret of passive-income investing is that you need to diversify your selection of income stocks, just as with your portfolio as a whole. It's pretty obvious why: If you derive all of your passive cash flow from a single business, and that business goes bust or faces stiff headwinds that require it to slash its payout, you're out of luck. And since dividend cuts are often a harbinger of further difficult times, you might even need to take steep losses on the price of your shares, not to mention the actual money into your account every quarter. 

So don't invest all of your passive-income capital into one stock. Try to have at least a dozen. And if possible, make sure that they're in various different industries and use different business models.

For instance, Innovative Industrial Properties and AbbVie compete in entirely different areas, and they aren't vulnerable to the same types of risk. So they'd be suitable options to buy for diversified passive income. When the economy is struggling or one of your companies hits a major stumble, you'll be grateful that only a portion of your dividend revenue takes a hit.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Alex Carchidi has positions in Innovative Industrial Properties. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Innovative Industrial Properties. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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