Many Britons invest for passive income. And in the cost-of-living crisis, that passive income could be more important than ever.
Of course, if I had £20,000 — the maximum annual ISA contribution limit — I could invest in stocks and shares now and look to achieve an 8% return in the form of dividends. That’s around £1,600 a year. This is a decent figure, but over time, I’m going to need more — especially if inflation remains elevated.
For me, 8% is pretty much the most I could achieve without compromising the sustainability of the dividend. But with these stocks, many of them financials, I wouldn’t expect too much in the way of share price growth.
So, how could I turn a £20k ISA into a handsome, lifelong passive income? Let’s take a closer look.
Compound returns
First, I’m looking at a strategy to grow my £20k ISA. A compound returns strategy involves reinvesting my dividends and earning interest on my interest. Essentially, it’s very much like a snowball effect.
So, let’s imagine I invest my £20,000 into stocks paying an 8% dividend on average. And instead of taking that dividend every year, I reinvest that money for a period of 10 years. Well, after 10 years, my £20,000 would be worth £44,500.
In fact, the longer I leave it, the more I’d have. The growth is exponential. After 30 years, the figure would be £212,000. That’s a huge amount of growth.
I could also enhance this my investing regularly. If I added just £200 a month and increased my contributions by 5% every year, after 30 years, I’d have £718,000.
However, let’s imagine I’m only reinvesting my returns for 10 years, but I’m going to be contributing £200 a month, and every year I’m going to increase that contribution by 5%. After 10 years, I’d have £88,900.
And, with £88,900 I could realistically look to achieve around £7,100 a year by investing in dividend stocks with 8% yields. That’s a decent return and considerably larger than what I could achieve now.
But of course, I know that my stock picks could underperform so nothing is guaranteed.
Picking stocks
Ok, so looking on the bright side, how do I get there? The strategy sounds great but I need to pick the right stocks. I need to invest in sustainable yields, and as I’ve noted, I think 8% is pretty much the highest I can achieve.
One way to tell if a company has a sustainable dividend yield is by using the dividend coverage ratio (DCR). This metric shows me how many times a company can pay its dividends from its earnings over a year.
A DCR of two and above is generally considered healthy. However, it’s worth noting that companies with lower DCR, but strong cash flows, can have healthy yields.
And what stocks would I pick? Well, there are a handful of companies that I like. Many of which, such as Phoenix Group, Legal & General, and Aviva, I’ve already added to my portfolio. These stocks have an 8.8%, 8.4% and 7.5% yield, respectively.
