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A Stocks and Shares ISA is my absolute top choice for building up a long-term passive income pot. And as we enter the New Year, I expect many potential investors will be planning to get started before the current ISA year ends.
Moving from planning to putting it into action is the first hurdle. And it can be down to just not being sure of how to tie all the steps and options together. So here’s a few suggestions that new investors might want to consider.
Get the money in
The first step I reckon we should take is to just start getting the cash transferred into our ISA. Whether it’s a lump sum or regular payments, we don’t have to decide what to buy in any hurry. Paying in before the April deadline and buying shares after it is fine, and doesn’t affect our new ISA allowance.
Once the cash is in, we have to think about the best strategy. Many people will assume passive income means we should buy shares that pay good dividends. And once we retire and want to start drawing income, that can make a lot of sense. But in the years before then, it really doesn’t matter what kind of stocks we buy. Wise investors use their dividends to buy more shares during the build-up years. And all that really counts is the total return.
Anyone who bought Rolls-Royce Holdings shares five years ago, for example, would today be sitting on a 900% gain. And selling the shares could help fund a pretty sizeable investment in dividend stocks today.
Follow the yield
Saying that, going for shares that pay good dividends is possibly the most popular strategy among passive income investors. And reinvesting the cash every year in new shares is key to the plan.
Let’s imagine someone who invests £500 per month and earns 5% in dividends per year plus 2% in share price rises — a total return very close to the past 20-year FTSE 100 average.
If they took out and spent their dividends, share price rises could push their ISA total to £147,000 in 20 years. But using the dividends to buy new shares could boost that to £255,000. And higher yields would make an even bigger difference.
A sample passive income stock
Aviva (LSE: AV.) is one of my favourite stocks for passive income, with a 5.4% forecast dividend yield. And since I first bought some before CEO Amanda Blanc shook the company up, the share price has risen nicely too.
But before anyone considers joining me and buying some, I want to make the the main risk clear. And then I’ll explain why I’m happy to take it. The thing is, the insurance sector can be notoriously cyclical — after all, the nature of the business is to take on other people’s risk.
Dividends are never guaranteed with any stock, and I suspect Aviva’s will fluctuate more than most. And the reason I’m not too worried? I invest for the long term, which helps smooth out short-term ups and downs in dividends and share prices.
But don’t forget — whatever strategy we choose, getting the money in is the key first step.
