A Stocks and Shares ISA can be a great platform to generate passive income streams. How well that works depends in part on the approach an investor takes.
Here are three different strategies an investor could consider to try and generate £2,000 of passive income annually from a Stocks and Shares ISA.
The high-yield approach
An obvious sum here is that £2k is 10% of £20k. So, investing in a mixed bag of high-yield shares with an average of 10% could produce the desired results.
On paper that adds up. But there are some key risks to consider.
A 10% yield is unusually high. The highest-yielding share in the FTSE 100 is ad group WPP (LSE: WPP) but its 9.3% yield falls short of 10%. The FTSE 250 offers some 10%+ yielders, though, such as NextEnergy Solar Fund (11.5%) and SDCL Efficiency Income Trust (10.7%).
Are those yields sustainable?
WPP cut its dividend five years ago. This month its share price hit a 16-year low as AI threatens to eat into revenues and profits. That could put another dividend cut on the table at some point.
NextEnergy Solar Fund and SDCL Efficiency Income Trust have both raised their dividend per share annually in recent years.
But past performance is no guide to the future. Both sell at a discount of over 20% to net asset value, suggesting the City has marked concerns about future performance.
High-yield shares can be lucrative, but they can also be high risk.
The compounding approach
Actually, I bought WPP shares this year. As part of a diversified portfolio of FTSE 100 income shares, I hope the holding may boost my passive income streams.
WPP has a large addressable market, proven business model, and large client base. That helps give it the sort of business performance I like. Now, AI is definitely a challenge and the high yield is a red flag. But, although the risks are notable, I think WPP has the sort of characteristics I seek when hunting for shares to buy.
Currently the average FTSE 100 yield is 3.3%. But in today’s market, I think it is realistic to target a 6% average yield while sticking to blue-chip shares with proven business models.
Now, 6% is a long way off 10%. But this is where reinvesting dividends (known as compounding) can help.
Compounding a £20,000 Stocks and Shares ISA at 6% annually means it should be worth almost £33,800 after 9 years. At a 6% dividend yield, that would produce £2,000 of passive income per year.
The dividend growth approach
A third option could be to take dividends out as passive income from day one, while relying on dividend growth to bring the average yield up to 10% over time.
Some FTSE 100 companies including Spirax and Diageo have grown their dividend per share for decades.
Other shares, such as Judges Scientific, have increased their dividend per share annually by 10% for years.
But with Judges’ current yield of 1.3%, even 10% annual growth would mean a 23-year wait to hit a 10% yield.
Still, investing in shares with a higher yield and strong dividend growth prospects could mean this strategy works on a shorter timeframe, while the Stocks and Shares ISA generates passive income along the way (unlike in my compounding example).
