4 Things All Dividend Investors Need to Know About Building Passive Income Right Now

As tech, artificial intelligence (AI), semiconductor, and the "Magnificent Seven" stocks turn more volatile, investors are rediscovering the appeal of boring dividend-paying companies. (The Magnificent Seven term refers to Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla, and Meta Platforms.)

Year to date, the WisdomTree U.S. Total Dividend ETF (NYSEMKT: DTD) is beating the Vanguard S&P 500 ETF (NYSEMKT: VOO) by roughly 2%. On top of that, it's achieved that outperformance with substantially less volatility than the S&P 500 index.

But dividend investing is one area where you can't just "buy the index." There are so many flavors and strategies for investing in dividend stocks that you really have to understand what your objective is, what type of income you're looking to generate, and most importantly what's actually in the dividend exchange-traded fund (ETF) you're choosing.

If you're investing in dividend stocks or ETFs, here are four general guidelines to follow that should set you on the path to success.

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Check the payout ratio and free cash flow before buying

A high yield is nice, but you have to make sure that it's sustainable. The only way to do that is to look at the balance sheet.

Cash flow is what helps companies pay the bills. Free cash flow is what companies have left over after they've paid the bills and reinvested back into the business. The more free cash flow that's on the books, the greater the ability of the company to pay and grow their dividends over time.

The payout ratio tells you how much of a company's net income is going toward dividend payments. The lower the payout ratio, the more sustainable the dividend is likely to be.

If you see a company that looks solid on both numbers, odds are it's a good long-term dividend stock candidate.

Spread your holdings across sectors to mitigate risks

Some sectors tend to pay higher yields than others. Utilities often fall in this category. Real estate investment trusts (REITs) actually have to pay out a large percentage of their income as dividends, so they're usually high yielders as well. But that doesn't mean you should load up on just these sectors.

Utilities and real estate are both interest-rate sensitive and can fluctuate. Dividend stocks from other sectors, such as consumer staples and healthcare, tend to be more durable and better able to withstand different economic environments despite lower yields.

Owning a mix of these improves diversification and can help protect your overall passive income stream.

Favor companies with a history of dividend growth

Companies that have raised their dividend payouts for many years are likely to continue doing so. In many cases, they're not the most exciting companies, and their yields are smaller. But the consistent dividend growth is the real selling point of these.

If the inflation rate is around 3% but the company raises its dividend by 3%, your purchasing power is protected, and your real passive income stream keeps up. That's an underrated advantage of investing in dividend growth stocks.

Keep some cash on hand just in case

Having at least a little money on the sidelines allows you to take advantage of bargains when they appear and to earn a nice yield with no risk. You don't want to have to sell your portfolio holdings just to pay the bills.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.