With a long-term perspective on financial planning, I think using my Stocks and Shares ISA in the right way could help me build wealth in the coming decades. For example, if I wanted to target a second income of £10,000 per year, I think I could work towards it by investing my ISA in the right way.
Compounding
Key to this is the idea of compounding.
Imagine pushing a snowball down a hill. As it moves, it picks up snow, which in turn picks up more snow. So it does not get bigger at a uniform rate. The more it grows, the faster it keeps growing.
A less charming example is an unpaid credit card bill. Over time, such a bill can balloon because the unpaid interest also starts generating more interest to be paid.
Financially though, the principle of compounding does not have to work against me.
I could use it to my advantage when it comes to a Stocks and Shares ISA. If I let gains in the ISA compound over the course of years rather than pull them out as cash, I could see my long-term returns get bigger.
Interest and capital gains
As an example, consider dividends.
If my £20,000 ISA was invested at an average yield of 7%, I would earn £1,400 annually in dividends. But if I let those dividends compound, after a decade I would be earning £2,754 each year in dividends.
It is not just interest that can compound. My capital gains could compound. If I invest in shares that rise in value and later sell them, I will have more money to invest than I started with.
So in my ISA I hold both income shares like British American Tobacco and growth picks such as Alphabet.
If I compound my £20,000 initial investment at an average annual rate of 8%, after 24 years I will have a portfolio worth over £125,000.
Setting up the second income
If I could generate an 8% dividend yield on that amount, I would hit my target of earning £10,000 each year from my ISA in dividends.
But, to generate that second income, I need a yield of 8%. That is not necessarily the same as a compound annual gain of 8%. In my example above, compounding capital gains helped me grow the size of my ISA. But turning that into a regular dividend income would require me to own shares that pay dividends.
I do not need to do that at first. But once I want to draw my second income, I would load up the ISA with dividend shares.
In my example I use 8%, fairly high for a dividend yield. But I think it is achievable even when sticking to blue-chip shares. British American Tobacco, for example, currently has an 8.2% yield.
Investing for the long term and buying into quality companies at the right price could help me earn a five-figure sum far into the future.
