The maximum annual allowance for a Stocks and Shares ISA today is £20,000. Fortunately, that’s more than enough to start generating over a grand a year in dividend income. Here’s how I’d do it.
Buy the index
The UK stock market is chock-a-block with high-yield dividend stocks. Actually, when I’m looking to add fresh capital to the income side of my portfolio, I’m spoilt for choice.
So I’d just start with the whole FTSE 100 index first. The Footsie currently has an average forward yield of 3.7%. I’d buy an index fund and benefit instantly from the diversification that it provides.
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Aiming for above average
But the index wouldn’t be enough on its own to pay me over a grand a year in passive income. So I’d also need to identify some quality stocks that could pay more than the average index yield.
Luckily, there’s actually an abundance of these in the UK market today. And most are established, cash-generative businesses with strong competitive advantages.
For example, take insurer Legal & General. The stock offers a forecast yield of 7.2%. That’s nearly double the market average! And that dividend is predicted to keep growing over the next couple of years.
L&G is a stable and profitable business that is exactly the type of investment I’d look for. Others I’d consider include oil giant BP (above 4% yield), miner Rio Tinto (above 7%), and utility giant National Grid (5%). That’s precisely why I own the last two of these stocks myself.
All of these firms produce plenty of profits and have very strong competitive positions. Hence why I think their dividends have a great chance of being sustainable over the long run.
Avoid reaching for the stars
Finally, one thing I wouldn’t do is get giddy with big dividend yields. Sure, a stock with a yield of 15% sounds much more exciting than one yielding just 5%.
That is, until the dividend suddenly gets cut and the share price falls in response. Then I’d wish I had opted for the more modest 5% yield.
Often, a company’s high yield can be a sign of trouble in its underlying business. And when the market gets a sniff of a firm’s weakening fundamentals, the stock price will more often than not fall.
When a stock price declines, the dividend yield will increase. That’s because a stock’s yield is inversely related to its price. So a falling share price could signal increased risk rather than an increased income bonanza.
That’s why I would tread carefully with ultra-high-yield dividend stocks.
Passive income
Of course, any dividend could be cut, especially during a recession. Nearly all stocks and sectors have the potential to be volatile during an economic downturn.
That’s why it’s important to diversify. And also why I think having a portion of my portfolio in the overall index is a smart move.
But finding 10 or so of those high-yield dividend stocks to sit alongside the index could potentially push the overall yield of my portfolio above 5%. And anything above that figure would equate to over a grand a year in passive income.
