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One of the things I like about owning dividend stocks in my ISA is the dividend income I can earn. This can be useful as a passive source of income. But I could also reinvest those dividends (known as compounding) to try to increase my long-term returns.
By doing that, I think you could try using a £20,000 ISA to generate £2,000 a year in dividends for the next six years. This is how.
Performance above the average of quality companies
Imagine I invest the £20,000 ISA with an average return of 7% and reinvest it. Ignoring the impact of share price changes (which could work for or against me), a compound annual gain of 7% would mean that after six years my 7% yielding ISA should be big enough to generate over £2,000 in dividends. annually.
At that point, instead of continuing to accumulate dividends, you could start withdrawing them as passive income streams.
7% is well above average for a blue-chip company. FTSE 100 company. The average FTSE 100 company currently yields 3.6%.
Still, that's just a average. Some stocks offer more, including what I consider excellent businesses with strong income-generating potential.
Find stocks to buy
Diversification is an important risk management strategy. With a £20,000 ISA, my aim would be to spread my money across five to ten different stocks.
To illustrate the type of stocks I think investors should consider buying, I'll focus on two.
one of them is Legal and general (LSE: LGEN).
The FTSE 100 company has a history of increasing its annual dividend frequently. It aims for 2% annual dividend per share growth in the coming years and it already yields a juicy 8.9%.
Still, no dividend is ever guaranteed. Legal & General cut its payouts in the last financial crisis and I see the risk of the same thing happening next time the markets crash if policyholders get nervous and valuations of the company's investment portfolio suddenly fall.
Still, I like the company's focus on investment products tied to retirement. It's a big market and I hope it stays that way. Thanks to its focus, industry experience and iconic umbrella brand, Legal & General appears well positioned to benefit from this.
Beyond the FTSE 100
As I said, I like to invest in great proven companies. But I also consider small and medium-sized companies, including those in the FTSE 250 index.
For example, one FTSE 250 stock that I think income-focused investors should consider for their ISA is a household name. itv (LSE: ITV).
Its current yield of 6.7% is slightly below the target I mentioned above, but since this is an average, you could still be affected if you own the right mix of stocks yielding above or below 7%.
ITV management intends to maintain the annual dividend per share. But after falling 51% in five years, ITV's share price suggests the City has doubts.
One risk is an ever-expanding universe of digital competitors driving away ITV's traditional audience.
Still, that competition could help the ITV division that rents studio space and offers production assistance.
Meanwhile, it is expanding its own digital footprint and continuing to operate a significant legacy business.
