How to Invest and Pick Dividend Stocks for Passive Income

Passive income may sound like a dream, and it does seem like a beacon of light to many investors.

Earning money while you sleep gives you a sense of peace, comfort and a bit of a financial cushion as long as you sink your money into the right types of investments. You can use dividend stocks to achieve passive income, but it requires having a plan and knowing where and how to invest. 

In this article, we'll walk through the definitions of dividend stocks and passive income and go over the steps to start earning passive income through dividend stocks. Finally, we'll mention three dividend stocks for passive income that you might want to add to your portfolio.

What Are Dividend Stocks?

When publicly traded companies pay out dividends, they share profits on an ongoing basis with shareholders. They may make dividend payments monthly, quarterly, semiannually or annually, depending on the performance and prerogatives of the company. A company's board of directors must approve the dividend and then will announce when the dividend will be paid, how much each shareholder will receive, as well as the ex-dividend date, which is the date you need to be a shareholder in order to receive the dividend.

Dividend stocks often go out to investors in the form of cash, though you might also get paid through extra shares of stock. 

For example, let's say a company announces a June 15 ex-dividend date. Let's also say that you bought 50 shares of XYZ stock on June 1. You'd receive the dividend on the payment date because you bought well in advance of the ex-dividend date. In this case, let's say XYZ stock pays out an annual dividend of $1 per share. You'd receive $50 in dividends for that year.

What is Passive Income?

Passive income is just that — income you earn with little effort. It's a great way to help you earn extra cash, potentially in addition to the money you make through your regular job. Passive income can help supplement your income to give you extra security. 

You may have also heard of active investing and passive investing, which follows the same idea. When investing, active investors take a hands-on approach. For example, let's say a portfolio manager constantly makes stock trades for you in order to earn money on your behalf: that's an example of active investing. 

Passive investing, on the other hand, takes a "set-it-and-forget-it" approach, which means that you don't buy and sell your shares constantly. Instead, you hold onto your funds and may start tapping into them when you retire.

How to Invest in Dividend Stocks for Passive Income

So, how do you invest in dividend stocks for passive income? Let's take a quick look at some of the steps for investing in dividend stocks for a steady passive income stream.

Step 1: Evaluate stocks for passive income potential.

You'll want to dive into the details of dividend stocks. Check the dividend yield, which shows how much a company pays out in dividends relative to its stock price. Steer clear of companies that seem to pay out a much higher dividend than other companies in their sectors. For example, if a company pays out a 15% dividend but every other company in the sector hovers around 5%, it could be a red flag. Look into the company further to make sure it's not on shaky territory.

Next, look at the payout ratio. This will tell you how much income goes toward company dividends. A too-high payout ratio (one around 80%) means that a company might be putting too much of its income into paying dividends and can't really afford to do so.

Step 2: Choose a brokerage.

Do you already have an online brokerage account? If so, you've already done some hard work. 

If you don't already have a brokerage account, it's time to hit the internet and do some research. You can take a look at the details of various brokers, checking on the track record of each one as well as the commissions you'll pay. You can learn a lot from online sources about the best brokerages. 

Look into account minimums and fees, pricing and execution. How much will you pay to own the account and buy and sell your investments? 

Finally, look into the bells and whistles: Tools, education and the platform. How easy is it to operate? Do you prefer a brokerage that does a lot of hand-holding or do you prefer to invest on your own? If you're comfortable with assistance from a robo-advisor, a type of advisor that helps you select investments based on your investment preferences, time horizon and risk tolerance, seriously consider that option. On the other hand, you may feel more comfortable having a human advisor help you. Just make sure that person is a fiduciary financial advisor — someone who has your best interests at heart.

Step 3: Decide how much you want to invest.

Don't skip over thinking about this all-important step! Deciding how much you want to invest means making sure you don't pour all your hard-earned money into one investment. You could lose all your money.

You want to be diversified. This means that you invest in a wide variety of assets instead of a single stock. You might consider investing in an exchange-traded fund (ETF). This means that you invest in a basket of securities that track an underlying index. It's a great approach because if some stocks in this "basket" decline, others may go up, which means you can more easily balance losses. 

Learn more: 8 Best Dividend Stock ETFs and How to Invest in Them 

Step 4: Invest. 

Once you've considered your goals, several passive income dividend options and chosen a brokerage account, whew! Pat yourself on the back. It's not easy to get to this point, but the next step is the most fun. You'll choose the number of stocks you want to purchase, choose your order and hit "buy."

You'll typically choose between a market order (buying or selling a stock at the best available market price) and a limit order (where you indicate the price at which you want to execute your trade). For example, if you want to hold steady at buying a stock at $85 but a stock is currently trading at $90 per share, you can enter a limit order and tell your broker to wait until the price sinks to $85 before you buy.

A market order is usually best for buy-and-hold investors, particularly because they'll hold the stock for a long time. On the other hand, you might want to choose a limit order due to market volatility or when you really want to get a good price for a stock.

3 Dividend Stocks for Passive Income

You can choose from hundreds of passive income options, but we've listed a few examples below. You can consider any of the Dividend Kings or Dividend Aristocrats and be in good hands, which is where we chose the next three stocks we're featuring.

Learn more: Dividend Kings vs. Dividend Aristocrats: Which Should You Choose?

Coca-Cola Consolidated Inc. (NASDAQ: COKE)

Coca-Cola Consolidated Inc., headquartered in Charlotte, North Carolina, manufactures, markets, and distributes beverages, including carbonated beverages, post-mix products, fountain syrup, energy products, non-carbonated beverages and more. The company sells its products in grocery stores, mass merchandise stores, club stores, convenience stores and in a wide variety of other locations.

Luckily, the company's watching its back: It has taken note of people's aversion to soft drinks and expanded into other beverage areas, which continues to look promising. The company continues to increase its dividend each year and has done so for over 50 years, putting it squarely in the passive income must-purchase category.

3M (NYSE: MMM)

The 3M Company, headquartered in St. Paul, Minnesota, makes a lot of products: abrasives and finishing for metalworking applications, auto body repair solutions, closure systems, packaging materials, electrical products and materials for construction and maintenance, structural adhesives and tapes, natural and color-coated mineral granules for shingles, attachment tapes, packaging and interconnection solutions, food safety indicator solutions, dentistry and orthodontic solutions — the list goes on and on, to tally over 60,000 products in many business lines. (3M even makes Post-It notes!)

The company has raised its dividend over the course of more than 60 years, making it a quality passive income king for your portfolio.

Colgate-Palmolive Company (NYSE: CL)

The Colgate-Palmolive Company, headquartered in New York, doesn't just make toothpaste. It makes and sells toothbrushes, mouthwash, bar, and liquid hand soaps, shower gels, shampoos, conditioners, deodorants and antiperspirants, skin health products, dishwashing detergents and more. It also makes pharmaceutical products for dentists and pet nutrition products under the Hill's Science Diet brand. 

Colgate-Palmolive fields returns from markets like Latin America and Asia and offers increasing solid dividends. The company has increased its dividend over 50 consecutive years.

Invest in Dividend Stocks for Passive Income 

Investing in dividend stocks may be one of the best passive income approaches you can take.  All you have to do is make the initial investment, then sit back and rake in the dividends that you receive. 

If you get really ambitious, you may want to consider building multiple passive income streams. For example, you can invest in passive income-generating stocks, bring in rental income from a rental property and/or earn money from a blog in which you sell advertising space. The sky's the limit, so consider all your passive income options once you get going.