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What type of companies should investors buy in their stocks and Shares ISA? The answer varies depending on the investor's goals and risk tolerance. However, for those seeking passive income, holding dividend stocks within an ISA is a proven and lucrative strategy.
With that in mind, let's explore how to start earning £500 every month starting from scratch.
Unlock an ISA income
On average, the UK stock market typically generates around 8% total returns each year. At least, that's what the long-term performance of the FTSE 100 indicates. And the general rule of thumb is to withdraw only about 4% of a portfolio each year for passive income. That way, a portfolio can still grow over time.
Let's continue with this restriction. Withdrawing £500 a month is equivalent to £6,000 a year. And following the 4% rule, that would require an investor to have a stocks and Shares ISA worth £150,000.
Obviously, that's quite a bit of money. But the good news is that even for those starting from scratch, it's not an unattainable sum if investors are willing to be patient. By consistently pumping money from a monthly salary into an ISA, it is possible to reach this six-figure threshold within a few years.
Let's say you would put £500 to work each month. With an annualized return of 8%, my portfolio would reach the £150,000 target in 14 years. Obviously, the wait is a bit long to earn significant passive income. Fortunately, there are two tactics investors can use to shorten this time frame.
Accelerate wealth creation
Instead of investing £500 each month to build a £150,000 portfolio, you could contribute more. This is by far the easiest way to accelerate the wealth creation process. And by maximizing the annual ISA contribution limit, the timeline could be reduced to just six years.
Unfortunately, not everyone is lucky enough to have £1,667 to spare each month. That leaves us with option two: increase the rate of return with stock picking.
Instead of investing in the entire FTSE 100 through an index fund, investors can choose to own individual companies directly. And when this strategy is executed intelligently, the returns can be significantly higher. Carry Diploma (LSE:DPLM) as an example.
This logistics and distribution company plays a crucial role in helping companies in the aerospace, biotechnology and industrial industries maintain their supply chains. So it's no surprise that Diploma has vastly outperformed the FTSE 100 over the past 10 years.
Including dividends, this stock has generated an annualized total return of 22.6%. And investing £500 at this rate of return would translate into £150,000 in less than nine years.
Everything has its risks
Not all FTSE 100 stocks have been as successful as Diploma. In fact, there have been many companies that greatly underperformed over the same period. Some have even fallen into bankruptcy. Stock pickers are much more exposed to these types of risks. And even Diploma has had its fair share of challenges over the years, including extensive competition, a threat that persists today.
However, risk can be managed with tactics such as diversification. And by being selective and clever, investors could discover the next Diploma stock to blow up their stocks and Shares ISA.
