I try to generate passive income by investing in my Stocks and Shares ISA. Right now, if I had a spare £20,000 to invest, here is how I would use it to try and generate annual income of £1,250.
A diversified ISA
I would not want to rely on just one or two shares to try and hit my objective. If one of them suddenly decided to cancel its dividend, for example, that could mean a big drop in my income. So, I would diversify my Stocks and Shares ISA across a range of companies.
With £20,000, I could put £2,000 into each of 10 different shares.
Choosing income shares
What sort of shares would I consider buying for my ISA?
I would stick to business areas I felt I understood, as that would help me assess the prospects of the companies. To pay dividends consistently, a company needs a business model that is set to generate spare cash. So I would look at the business model of each company I considered and decide whether I felt it was likely to generate excess cash in years to come.
For example, does the company operate in a market that is set to continue experiencing strong customer demand? Does it have a proven competitive advantage in that market, like a unique set of assets or patented process?
I would also look at a company’s balance sheet. If it has a lot of debt, that could constrain its future ability to pay dividends even if it makes big profits. Instead of paying them out to shareholders, the company may need to use such profits to service its debt.
Average yield
In order to generate £1,250 in annual dividend income from £20,000, I would need to be earning an average dividend yield of 6.25% from my portfolio of shares. That is an average. So not all the shares I choose would need to have such a high yield for me to meet my target, as long as other ones were higher.
For example, I might decide to invest in Tesco, which has a yield of 4.3%. That is below my target average yield of 6.25%. But I may buy shares like tobacco company Imperial Brands, which currently has a yield of 8.6%. As long as the average yield is 6.25% or higher, I should hopefully be on track to hit my dividend target. Dividends are never guaranteed, though, so that also depends on the companies I buy maintaining their payout.
Moving to action
To start earning income, I would need to put my plan into action. But once I had done that, I would not spend much time thinking about it.
From time to time I might check to see whether anything had changed the investment case for any of the shares I owned. But if not, having taken time to match the portfolio to my objective, I would follow a long-term investing approach. Instead of frequently trading, I would sit back — and hopefully start to see the dividends add up.
