There are plenty of investments out there that can offer passive income. Consider investment properties or bonds for example. However, many passive income buys don't offer the convenience and return potential of ASX dividend shares.
Unlike property, ASX dividend shares are notably liquid and don't demand a large deposit to buy.
And, while investing in dividend stocks can represent greater risk than buying bonds, they also offer greater potential rewards. Fortunately, I believe there are ways investors can minimise the risks involved with buying ASX dividend shares.
Here are three mistakes dividend investors often make when building a portfolio and how to avoid them.
3 mistakes I'd avoid when buying ASX passive income shares
Not looking at the bigger picture
The first mistake those buying ASX dividend shares often make is a simple one. That is, buying a stock purely for its dividends.
ASX dividend shares can provide both passive income and share price gains – or falls. Thus, I think it's important to assess the health of a whole company before buying in.
To do so, I would look at whether it's currently trading for a good price. If it is, I would then delve into its business and balance sheet to make sure I both understand the company and am confident of its future prospects.
Though, even the most considered investment can't be guaranteed to provide returns or downside protection.
Choosing passive income over quality companies
On that note, while a high yielding company might look like an obvious investment for one seeking passive income, I believe it's important to delve into the reliability of those dividends.
That means assessing a stock's dividend history and its cash flows.
By looking at the former I might find that, for instance, a company tends to cut its payouts during hard times. That might make it a less attractive income buy. However, past performance isn't an indication of future performance.
Meanwhile, the latter is important because dividends generally come from a company's free cash flow. Thus, an ASX dividend share with consistent cash flows might be more likely to provide consistent passive income.
Failing to diversify
Finally, while I wholeheartedly believe it's important to understand the businesses one invests in, it's equally important to build a diverse portfolio. Of course, that can be a tricky – but worthwhile – balance to strike.
By diversifying – buying into various companies, sectors, and asset classes – an investor can better protect their portfolio.
That's because unavoidable risks are spread across multiple investments while one maintains exposure to multiple potential opportunities.
On the other hand, failing to diversify could set an ASX passive income portfolio up to suffer in the event of a single-sector or company-specific downturn.
