My 2024 warning: Don't get (completely) lost in the passive income sauce

It's easy to become fixated on BIG yields to ease the cost of living pressures next year. Here's my word of warning when doing so.

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'Rizz' has been named Oxford Dictionary's word of the year. Yet, in the investing world, it feels like no other topic has been championed more than 'passive income' in 2023.

It makes sense. Many of us are battling the scourge of inflation while simultaneously contending with higher interest rates. It is a recipe for financial strain, by its very design, compelling us to find additional sources of income.

Hence, there has been an explosion in the popularity of dividend investing this year.

However, I'm concerned investors could be over-optimising their portfolios for passive income to the detriment of long-term wealth creation.

Allow me to explain.

Passive income can be like sugar

We are all taught from a young age, "everything in moderation". If you have a bit of a sweet tooth, this has been a tough lesson to learn, but important, nonetheless.

Sugar is addictive. It hooks us by triggering our feel-good chemical responses. We know it has zero nutritional value and can have harmful effects in excess amounts. Yet, some benefits from sugar can be enjoyed without too much downside if consumed responsibly.

But you didn't come here to get a lesson in nutrition… so how does this relate to passive income?

Dividends can be like sugar, in a way. Dividends are not intrinsically bad. Like sugar, the passive income from dividend investing is a nice-to-have. However, if we pack a portfolio full of ASX shares solely picked for their passive income potential, then Houston, we may have a problem.

See, the sugary hit of dividends can be addictive, too. Except, there's no point snacking constantly on dividends if your investments are decaying in the process.

Take Westpac Banking Corp (ASX: WBC), for example.

Excluding the COVID-19 period, the ASX 200 bank share has consistently provided a dividend yield of more than 5% to its shareholders — how's that for passive income? Yet, total shareholder returns over the past five years have been 9.8%, with dividends included (or roughly 2% per annum).

Westpac is not the only one. There are many examples of companies that look attractive from an income perspective but which have actually left investors worse off.

Counter-intuitive alternative

Not all big dividend payers will end up this way. It's important to understand your own investment goals and act accordingly. However, a legendary investor proposed an alternative to dividends while keeping the passive income dream alive.

Buy shares in great companies and then sell them… it seems ludicrous, but here's the reasoning.

Terry Smith, founder and CEO of Fundsmith, firmly believes an income strategy doesn't require dividends at all. In his book, Investing for Growth, Smith says investors should focus on total shareholder return.

Oftentimes, this ends up being companies capable of reinvesting their capital at attractive returns rather than paying dividends. If the company's value growth can outpace the desired income yield, then an investor could sell the desired amount of shares to supply the passive income.

It might not be for everyone. But, I think it is an important lesson as Aussies look to supplement their incomes in 2024.

Motley Fool contributor Mitchell Lawler has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. 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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