So, my target is to generate some passive income for later in life, and I’m starting with £20,000. What would I do?
I’d stick it all in a Cash ISA and sit back and watch the interest trickling in. No, only joking.
I can see the attraction of a Cash ISA today, with interest rates fairly good. And they have the advantage that the returns are guaranteed, for the duration of the term. Not paying any tax is a good thing too.
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.
Short-term vs. long-term risk
For anyone who really doesn’t want any stock market risk at all, a Cash ISA can make sense. And it can be a very good place to save short-term cash.
By short-term, I mean anything less than about 10 years. More than that, and we start to get past the short-term risk of a Stocks and Shares ISA. And the longer our horizon, the more the risk reduces, and the more I think it’s worth taking.
Barclays does regular research on returns from different kinds of investment, comparing the UK stock market to cash.
And when they looked at periods of around 20 years, cash never beat shares even once. In fact, in many periods, shares wiped the floor with cash.
Compounding
I mentioned tax, but that’s not the big ISA thing for me. No, it’s the ability to keep feeding in cash, buy more shares with it, and let the magic of compounding weave its spell over the decades.
How does that work? Let’s take the average Stocks and Shares ISA return of the past 10 years, of 9.6% annually.
A single year’s ISA allowance of £20,000 invested for 20 years would grow to how much? Would a sum of £125,000 be a surprise?
What about someone who could use their full £20,000 allowance every year for 20 years? Hang on to your hats… they could net more than £1.15m. And that could generate a very nice annual passive income.
Risk and balance
I’m not saying UK shares will average 9.6% per year for ever. But the long-term average return is around 7%, which is still pretty good.
And, right now, I think much of the FTSE 100 is undervaled. By all means take my musings with a pinch of salt, but I reckon the next decade could be a great one for stocks and shares investors.
There are ways to reduce risk too. The main one is to keep a balanced ISA with stocks chosen from across the sectors. Maybe also some international stocks. And perhaps an investment trust or two.
That would achieve diversification, which I think is key for any long-term investor.
What to buy?
Beyond this, investors need to work out their own strategy, and buy stocks they’re comfortable with. For me, that’s high-dividend FTSE 100 stocks. But ones with good cover by earnings, and strong long-term cash flow, not just a big yield.
These numbers are not predictions, and real returns could vary a lot. But I find the possibilties very persuasive.
