Passive income is the holy grail for many investors. Myself included.
But many of us don’t have a portfolio large enough to generate life-changing passive income. For example, even when invested in some of the biggest yielding dividend stocks on the FTSE 100, a £20k ISA would only generate £1,600 a year.
So how could I go about turning this £20k — the annual ISA contribution limit — into a much bigger pot that could provide me with more than £1,000 a month?
It’s important that I use the ISA vehicle to do this, as all gains within the wrapper are tax free. That’s why it’s such a great vehicle for our investments.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Building a bigger pot
There are many difference strategies for building a portfolio. Super-investors like Warren Buffett are known for their value investing approach, while Cathie Wood is known for her investments in disruptive technologies — in some cases this can mean speculative growth stocks.
But my choice for investing over the long run is a compound returns strategy. Essentially, people who already have money find it easier to get more money just by leaving their investments to grow by reinvesting the dividends year after year.
It’s very much like a snowball effect. The longer I let it roll, the larger the pot becomes.
So with £20,000, I’d invest in high-yielding but sustainable dividend stocks. And I’d reinvest the dividends every year. It’s not a guaranteed winning strategy, after all, dividends are never guaranteed. But if I pick my investments wisely, I believe the strategy should play out positively.
It’s also definitely worth highlighting that other strategies, including value and growth investing, have their pitfalls. Value investing can involve holding firms for very long periods of time, decades in fact. And look no further than the performance of Wood’s flagship Ark ETF in 2022 for reasons not for pursue a speculative growth-oriented portfolio.
Compounding
To earn £1,000 a month, or £12,000 a year, in passive income, I need to have £150,000 invested in stocks paying me an 8% dividend yield.
So how can I get there using a compound returns strategy? Well, if I invest my £20,000 in these stocks offering 8% yields, and reinvest my dividends year after year, and then contribute £200 a month — while increasing this contribution by 5% annually — after 14.5 years, I’d have £150,000.
At which point, I could start withdrawing. Of course, with compounding, the longer I leave it, the greater the growth rate becomes. It’s exponential because we’re earning interest on our interest. If I had the capacity to practice a compound returns strategy from the age of 18 to 68, the growth would be phenomenal.
For example, if we extend the above investment strategy over 50 years, the end figure is an incredible £4.2m. I know that my investments could underperform. But time and regular contributions really can be a winning combo.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
