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A stocks and shares ISA can be a way to benefit from long-term appreciation in company valuations, if the right decisions are made. However, down the road, an ISA can also be a powerful way to generate passive income.
Imagine you had a £20,000 stocks and shares ISA and wanted to aim for an average weekly dividend income of £130. Here's how you would do it.
Basic investment principles
My first step would be to have the money in a stocks and Shares ISA ready to invest.
Diversification is a simple but important risk management strategy. I would spread my ISA across about 10 different stocks equally to help achieve that diversification.
What type of stocks would you be looking for?
With long-term earnings as my goal, I would stick to proven blue-chip companies that have consistently generated cash and I believe could continue to be so.
Choosing Income stocks to Buy
An example of a stock I own is British American Tobacco (LSE: BATS).
The company owns premium brands such as Stroke of luck. That gives you pricing power. The cigarette market is huge and millions of customers buy regularly, even when the economy is bad.
British American generates a lot of cash. That helps it fund a sizable dividend, which has grown annually for more than 25 years.
There are clear risks here. The company's balance sheet has a lot of debt. A key risk is that fewer cigarette smokers will lead to decreased benefits in the future.
However, although fewer people smoke in many countries than before, the market remains substantial. British American has also been rapidly expanding its non-cigarette business.
The shares currently offer a dividend yield of 10.2%.
Aiming at a target
A double-digit performance of a FTSE 100 Participation is the exception and not the norm.
To reach my target of £130 a week on average in dividends from my stocks and Shares ISA, I would need to earn £6,760 a year.
With a £20,000 ISA, you wouldn't expect to earn that at the start. But if you initially reinvested the dividends earned, you could accumulate them over time.
As an example, let's say I earned an average return of 8% on my stocks and Shares ISA, well below what I get from British American, but still slightly above double the average for the FTSE 100. By doing that, after 19 year old would be earning over £130 a week on average in dividends.
As a long-term investor, that wait is good for me. But I could start earning income sooner by stopping compounding and taking my dividends in cash, if I were willing to settle for a lower target.
