Creating a passive income stream is a common financial goal for many Britons today and it’s easy to see why. With this form of income, one gets cash flow without having to work for it.
Now, building up savings in a Stocks and Shares ISA and investing in dividend stocks can be a good way to create a passive income stream. But how much capital would someone need in an ISA to generate income of £20k per year?
What yield could be achieved?
This answer to this question depends on the yield the investor would be targeting.
On the London Stock Exchange, there are plenty of dividend stocks that offer yields of 8%, 10%, or more. But generally speaking, these stocks are quite risky.
History shows that high-yield dividend shares often turn out to be poor investments in the long run. With these stocks, there’s often something fundamentally wrong, and it’s not uncommon to experience both share price losses and reduced dividends.
A high yielder that bombed
A good example here is Vodafone (LSE: VOD)
Two years ago, it was trading for around 90p and offering a yield of about 9%. That yield wasn’t sustainable though. And the dividend payout was cut (quite significantly).
The market didn’t like this. And by early 2024, the share price had fallen to around 65p. So, not only were investors faced with lower-than-expected dividend income but they were also hit with substantial share price losses. Not a good result.
Personally, I think cutting the dividend was the right move. At the time, the company needed to conserve cash as its balance sheet was quite weak.
Today, the company is in a stronger financial position as a result of the cut and the shares are almost 73p each. That said, I’m still not convinced the stock is a Buy as its debt is pretty high (net debt of €32bn at the end of September 2024) and growth is quite underwhelming.
Taking less risk
If an investor was targeting passive income, I think they should probably aim for an overall yield of 5%-6%. This would result in a less risky portfolio.
For a 5% yield, they’d need £400,000 to generate £20k per year in income. For a 6% yield, they’d need about £333,333.
When choosing dividend stocks to buy, they should be selective. I wouldn’t just invest in a stock simply because it had an attractive yield.
Instead, I think investors need to look for companies with substantial long-term growth potential. I’d also look for businesses with competitive advantages and strong financials.
These kinds of companies often increase their dividends over time (resulting in increased income for investors). And they can produce share price growth too.
HSBC is an example of the type of dividend stock worth considering. It currently sports a dividend yield of around 5.75%.
There’s no guarantee it would do well, as banking is a cyclical industry. But with its exposure to Asia and wealth management, I think it has quite a bit of long-term potential.
