Investing is a great way to generate a second income. I consider investing in stocks to be far superior to investing in bricks and mortar, where the returns on buy-to-let tend to be south of 5% when I take all costs into account.
Last week, I detailed how I could invest a £20,000 ISA contribution limit in stocks to generate an annual £1,500 return, starting from the first year. But today, I’m looking at how I can generate £3,000 a year from a £20,000 ISA. The big difference is, I need to reinvest for 10 years before taking a second income from the ISA.
So let’s take a look at how that could be achieved.
High-dividend stocks
Both parts of my strategy require me to invest in dividend stocks. In order to achieve £3,000 in dividends, I need to have around £40,000 invested in stocks with an average dividend yield of 7.5%. For me, 7.5% is around the maximum I can achieve without sacrificing the sustainability of the yield.
Under normal circumstances, it may not be that easy to average 7.5% in dividend yields. But this has been made easier by the March correction, during which shares in financials and housing, among other sectors, slumped. That’s useful because when share prices go down, dividend yields go up.
It’s important to note that the slump, triggered by the collapse of Silicon Valley Bank, appears largely unwarranted. So dividend yields have been pushed upwards, but there’s no compromise on sustainability.
However, I also need to pay attention to the sustainability of the yield. One way of doing this is the dividend coverage ratio. A ratio around two suggests the yield is sustainable. But a lower ratio is still fine if a company has solid cash generation.
So here are some of my options.
| Stocks | Dividend Yield |
| Aviva | 7.3% |
| Close Brothers Group | 7.4% |
| Legal & General | 8% |
| Phoenix Group Holdings | 9.1% |
| Sociedad Química y Minera | 14% |
| Steppe Cement | 11.5% |
| Vodafone | 8.2% |
Building my investments
As noted, if I want to achieve a £3,000 in dividend income, I need to have £40,000 invested in stocks averaging a 7.5% yield.
So how do I turn £20,000 in an ISA into £40,000? Well, it’ll take 10 years. But if I use a compound returns strategy, invest in stocks paying a 7.5% yield, and reinvest these dividends annually for a decade, at the end of the period I’ll have £40,000.
Of course, the longer I leave it for, the more money I’ll have by using a compound returns strategy. But I know there’s a risk my stocks could fall too and dividends could be cut.
My picks
Financial stocks look great to me right now. I’ve recently topped up on Aviva, Legal & General and Phoenix Group. I’m also increasingly looking at health insurance companies like Aviva as concerns rise about the capacity of the NHS. Although I’m aware that claims inflation is presenting challenges to these companies.
But I also see strong offerings in multiple sectors. I like banks right now, with several, such as Lloyds, offering yields above 5%. Naturally, there are concerns about the impact of very high interest rates on debt quality. Yet I’m buying these stocks for the medium term when interest rates are forecast to fall to ideal levels, between 2% and 3%.
