Humans are very good at linear thinking. We tend to gravitate towards logical and orderly patterns. For income investors linear thinking often means simply buying the highest yielding investments.

On the surface this makes sense. If you have $1000 to invest and a choice between a share yielding 7% and a share yielding 5% it makes sense to buy the first share. You will receive $20 more per year in income.

Investing would be a lot easier if linear thinking worked. When it comes to income investing that is sadly not the case. Being a successful income investor involves a lot more than simply buying high yielding investments. It means avoiding common mistakes.

Mistake 1: Not properly defining your goal

I’ve been an advocate for a goals-based investment approach for years. The more I talk about the importance of goals the more it becomes clear that most investors don’t want to listen to me. We have been conditioned to think the most important part of investing is investments. This mindset means that investors naturally jump to which share, bond, fund or ETF to buy.

This isn’t surprising. We’ve been pre-conditioned to think this way by a product focused investment industry. Most companies in the investment industry want to either sell you a new investment product or want you to constantly buy and sell products to earn trading fees.

This contrasts with what most investors want. Investors want an outcome. It may be a comfortable retirement, buying a house or providing for loved ones. All of our outcomes are as unique as each of us. Every share, bond, fund or ETF in our portfolio is simply a way to facilitate our desired outcome.

I’m an income investor. It would be easier to define my goal as simply generating the most income possible right now. However, that short-cut goal doesn’t encapsulate what I actually want. I want to generate income from my portfolio to supplement my wages and pay for experiences that I want to have. It is not the income I want. It is what it buys me.

This has several implications. I don’t just want to have those experiences this year. I want to have them for the rest of my life. And I want more of them. That means that my passive income needs to grow faster than inflation.

This simple exercise of stating my goal in terms of what I want my portfolio to enable rather that what I want it to be changes my investment strategy. It turns out that I don’t want the most income possible right now. I want a sustainable and growing income stream for the rest of my life.

Unless we define our goals in terms of what we want out of life it becomes very hard to figure out the right way to accomplish that goal. Failing to think through your goal means that your investment strategy won’t line up with the outcome you are trying to achieve.

Mistake 2: Falling into a dividend trap

To understand what a dividend trap is it is necessary to understand the basics of a dividend yield. The first step is understanding that paying a dividend and the size of the dividend paid is a choice. There is no guarantee that a dividend paid in the past will be paid again in the future.

Historical dividends can play a role in decision making. They indicate management’s willingness to pay dividends. They also indicate what percentage of earnings management is willing to pay. The decision-making process of different companies will vary based on the other opportunities available for earnings including investing in growth or paying off debt.

For mature companies with diminishing growth opportunities a high percentage of earnings may be paid in dividends. For fast growing companies with endless possibilities for growth a low percentage of earning may be paid in dividends. Over time it is likely a company will progress along this business lifecycle.

Along with a willingness to pay dividends a company also needs the ability to pay dividends. That means the future level of earnings matter. That is the pool of cash that will fund the dividend. And this is the key to the second part of the dividend yield. The share price. A dividend yield divides the dividend paid over the past 12 months by the share price.

Share prices reflect the future expectations of investors. If investors believe a company will perform poorly in the future share prices go down and dividend yields go up. Those yields are based on historical dividends. This is a dividend trap. The market has already anticipated that the dividend is not sustainable and adjusted the share price accordingly.

There are a couple things to note. The first is that investors may be wrong. Perhaps the consensus view of the prospects of a company are too negative. If investors are wrong, it could be a great opportunity to pick up a good income paying share at a discount.

The second thing to note is that not all investors care about income. Most professional investors don’t care at all. If the dividend is sustainable at a temporarily lower level of earnings this could also be a great time to pick up a high yielding share with a sustainable dividend that may start growing again in the future.

These two considerations don’t override the underlying point. Buying a high yielding share simply because it is high yielding is not a successful investment strategy. Most of the time the consensus view is correct and going against it will not work out.

To develop a contrarian view takes some homework. You must understand the company, the competitive environment it operates within and the concerns of most investors. You need to have reasonable certainty that everyone else is wrong. This is not an easy thing to do.

Mistake 3: Ignoring dividend growth

Avoiding dividend traps is likely not enough to accomplish the goals of most income investors. If you are a new income investor, a retired income investor or anyone in-between it is likely that dividend growth is needed to achieve your goal. I am an income investor because I want to use my dividends to pay for things that I want to do. Ignoring the fact that prices go up over time would foolhardy.

The beauty of dividends is that they can grow over time. This does not happen if you buy most bonds. Even an inflation protected bond will only maintain purchasing power over time by keeping pace with inflation.

The income stream from a portfolio of dividend paying shares can outpace inflation and increase purchasing power over time. This is a great outcome if you are spending your dividends today or if you are trying to compound a passive income stream for the future.

In most cases an investor must make a trade-off between higher yielding shares and shares with higher potential for dividend growth. This trade-off is again caused by future expectations being reflected in share prices. Investors like earnings growth and if a company’s earnings are expected to grow the share price will go up and the dividend yield will go down. And the driver of dividend growth is earnings growth. That is some linear thinking that is beneficial.

The trade-off is also reflected in the lifecycle of companies. Growth companies typically have at least the perception of long-periods of earnings growth. Most of their cash flows are reinvested into growth initiatives to take advantage of these opportunities. As a result, they often dedicate little or none of their cashflows to dividends. Another driver of low yields.

Mature companies typically have less opportunities for growth. They are either too big which makes it challenging to grow fast or they operate in an industry that has matured to low levels of growth and stable market shares. They will dedicate more of their cashflows to dividends. The slow growth prospects will result in low shares prices and yields will be high.

Making the trade-off between future growth and current yield is the art of income investing. And this is where goals and an investment strategy come into play. If you are spending dividends today and you have shorter time horizon it makes logical sense to have your overall portfolio yield exceed the yield of the index. If not, just buy the index.

If you are not spending your dividends today and building passive income for the future then your target dividend growth should be higher than the overall dividend growth of the index. If not, once again, just buy the index.

An example is illustrative of the trade-off between higher yielding shares and higher dividend growth. It also encompasses the dangers of dividend traps. Going back to 2014 we can look at the outcomes achieved by investing in either Telstra (ASX: TLS) or CSL (ASX: CSL).

On the surface it seems obvious that an income investor would have picked Telstra. In 2014 the dividend yield of Telstra was 5.90% while CSL had a yield of 1.65%. This snapshot in time didn’t tell the whole story.

The growth of CSL’s dividend over the last decade more than made up for the large difference in yield in 2014. If $10,000 of shares were purchased in 2014 a Telstra investor would currently have $354 in annual income. The dividend is currently lower than it was 10 years ago. The same $10,000 invested in CSL would result in $526 in income given the high dividend growth.

This is a bit of an extreme example. I’ve picked a company that has gone through some difficult times in Telstra and one of the recent success stories in Australian business in CSL. Yet the central point holds true.

Over time growth matters. Hypothetically, after 10 years an annual dividend growth rate of 5.3% on a share with a 4% yield would result in the same annual income as a 5% yielding share growing at 3%.

All income investors should have a mix between higher yielding shares with lower expected growth rates and lower yielding shares with higher expected growth rates. The percentage mix should be based on individual goals.

Mistake 4: A lack of patience

All investors suffer from a lack of patience. This adversely impacts outcomes. The most powerful force in investing is compounding. And the secret power of compounding is time. Time turns the combination of small amounts of money and returns into large amounts of money. Growing a passive income stream is no different.

There are three ways to grow a passive income stream. Dividend growth, saving money and buying new income generating assets, and reinvesting income. The chances are remote but an investor focusing on capital appreciation can see rapid growth if the right investment is purchased at the right time. None of the elements that contribute to passive income growth are going to increase as fast as a skyrocketing share.

The key to turning a small passive income stream into a large passive income stream is patiently waiting for dividends to grow and increasing the amount reinvested. The law of big numbers means that new savings will have a progressively smaller impact into passive income growth over time unless savings levels can grow significantly. Patience may be a virtue but in income investing it is necessity.

Would love to hear your thoughts on mistakes you’ve made if you are an income investor. Write me at

For more on income investing:


Get Morningstar’s insights in your inbox each morning. Sign-up for our email newsletters.