A Stocks and Shares ISA can be a vehicle for investing over the long term. That is true whether one’s focus is growth, income, or both.
Taking a long-term approach, I think putting £8,000 into an ISA now could help me target weekly dividend income of £100 on average.
Here’s how.
Building income streams
When targeting dividend income, the two variables that dictate what I might achieve are how much I invest and my average dividend yield.
Take my £8,000 example. If I had that much in a Stocks and Shares ISA earning an average yield of 5%, I ought to generate £400 in yearly dividends. At 8%, that would rise to £640.
£640 of passive income each year could certainly come in handy. Still, it is a long way from my target of £5,200. So, how might I aim for that even while earning an 8% yield on average?
Dividends on the dividends
In a word — compounding.
Basically, compounding involves reinvesting dividends rather than taking them as cash.
Over time, that could effectively mean I earn dividends on my dividends. This is the sort of snowball effect that billionaire investor Warren Buffett talks about.
Recall that I said above I would take a long-term approach to my Stocks and Shares ISA. If I compounded £8,000 at 8% annually, it would take me 28 years to build my portfolio to the point where I was earning £100 each week on average in dividends.
If I was impatient for the passive income, I could compound less (or none) of my dividends. That might give me cash in the short term, although I would need to adopt a much more modest target.
How to find brilliant shares to buy
In my example, I have used 8%. Is that realistic?
I think it is. I own a number of blue-chip shares currently offering a yield of 8% or more, including well-known names like Vodafone and M&G.
But I did not buy them purely because of the yield. Simply buying a share for its yield can be what is known as a value trap. Dividends are never guaranteed and a high yield can be a warning sign that some investors fear the payout may be cut.
Buying a high-yield share and then having that happen can be doubly disappointing. Not only is the dividend reduced (perhaps to nothing), but such a cut can also often lead to the share price falling.
So when deciding what to buy for my Stocks and Shares ISA, I always look to find brilliant businesses selling at an attractive valuation. Only then do I look at their yield.
This post was originally published on Motley Fool
