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With the right approach, a Stocks and Shares ISA can be a lucrative way to try and earn passive income.
Of course, it helps to have realistic expectations and a long-term approach.
Someone could target a four-figure monthly passive income in the form of dividends using a spare £20k to put such an approach into practice. Here’s how.
Letting dividends earn dividends
There are a couple of key elements that help explain how this plan works.
One is dividends. A dividend is spare money a company has generated that it pays out to shareholders. This is never guaranteed to happen (or keep happening), so it is important for an investor to choose carefully when investing their Stocks and Shares ISA.
Another element is compounding – basically reinvesting the dividends, so hopefully they in turn can earn dividends.
Compounding £20k at 8% annually for 30 years, it ought to grow to a size where an 8% dividend yield would be equivalent to £1,342 of dividends per month on average. Of course, it is important to remember that in 30 years’ time almost £1,400 will be worth a lot less than it is today.
Focus on quality businesses
Is an 8% compound annual growth rate realistic?
The current FTSE 100 dividend yield is 3.3%. Some blue-chip shares offer much higher dividend yields though.
Not only that, but the compound annual growth rate includes any share price gains, not just dividends. Conversely, share price declines would eat into it.
On balance, I do see a target 8% compound annual growth rate as potentially achievable.
To try and do so, I think an investor ought to focus on trying to fill their Stocks and Shares ISA with a diversified range of shares in high-quality, proven businesses.
Long-term dividend prospects
As an example of the sort of dividend share I think investors should consider, I would point to FTSE 100 insurer Aviva (LSE: AV).
Insurance is an industry that benefits from resilient long-term demand. With its long underwriting experience, Aviva is well-placed to price risks appropriately.
It has economies of scale too, thanks to being the UK’s largest insurer. While it has some overseas operations, in recent years Aviva has focused on consolidating its strong position in its home market, for example through its takeover of rival Direct Line.
That could help it to keep growing and also boost its profit margins, by cutting out duplicate functions. However, integrating acquisitions can lead to management taking eyes off the ball when it comes to the core business and I see this as a risk for Aviva.
It cut its dividend per share in 2020 but has since been growing it handsomely each year. The current yield is 5.4%.
Making smart choices from the first step
The share price performance and any dividends paid are not the only factors that help determine how much income the ISA generates. Fees, commissions and charges can eat into it.
So it makes sense in my opinion for an investor to spend some time choosing the right Stocks and Shares ISA for their own needs.
