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An ISA can be a good way to generate short-term passive income by investing in dividend stocks. There is no shortage of options on the London market right now that offer the potential for huge profits.
But as an investor who believes in a long-term investment approach, I also believe that an ISA can be useful when it comes to retirement planning.
To keep things simple, let's say I currently have a £20k stocks and shares ISA and plan to retire in 30 years.
Over £10,000 a year, every year, for doing nothing
Imagine I compound that at a rate of 7% per year for 30 years. This is well above the average performance of FTSE 100 shares, but I think it can be achieved in the current market.
That alone would mean that, within three decades, he would have a portfolio worth just over £162,000. At a 7% return, that should net me £11,363 in passive income. If I just take the dividends at that time and don't touch the principal, I could hopefully earn that amount every year.
I say “with a little luck“Because dividends are never guaranteed. I may take a cut in some stocks I own, which means I earn less. But the opposite is also true. I can earn more each year if I have stocks like Diageo continue its decades-long habit of annually increasing its dividends per share.
Establish a strategy for a five-figure annual passive income
So how am I going to do this?
The reality may sound disappointingly unglamorous.
My goal is to find companies that offer unique solutions in large and durable markets. I look for companies that generate much more cash than they need to keep their business running. I also take into account the share price and what it means for valuation, since smart investors don't overpay even for great businesses.
By building a diversified portfolio in my ISA of such stocks (diversification is important because even large companies can disappoint), I aim to generate increasing passive income streams over time.
Putting theory into practice.
So much for the concept. What about reality?
Let me illustrate by talking about a FTSE 100 share that I own, Legal and general.
Yes, it's a stellar return well above my example of 7% (which, to be fair, is close to double the average return of the FTSE 100 at the moment). Currently, it stands at 9.4%.
And yes, although it plans to reduce the level of annual dividend per share growth, the company is still aiming for a increase every year.
In fact, that has happened every year but one since the financial crisis. At that point, the payment was cut off. I see the risk of that happening again if the economy suddenly enters a very turbulent period, if policyholders withdraw more money than they bring in.
But remember: my investment approach is based on a long-term perspective.
I expect Legal & General to face turbulence from time to time, as befits a company that is almost 190 years old. But I'm also hopeful that it still deserves a place in my ISA thanks to its continued passive income potential.
